2. Define the real interest rate,r. Why does it differ from the nominal interest

Question

2. Define the real interest rate,r. Why does it differ from the nominal interest rate, i, in the presence of inflation?

3. Why does the actual real interest rate, r, generally differ from the expected real interest rate, r^e? How does this relation depend on whether bonds prescribe the nominal or real interest rate?

4. Why does the real interest rate, not the nominal interest rate, have intertemporal-substitution effects on consumption and saving? Does the same result apply for intertemporal substitution of labor supply?

Explanation / Answer

Answer:

Real interest rate (r):

       The real interest rate does take inflation into the account. It means that who saves or lends, they receive or expects after allowing for inflation. By the Fisher; real interest can be defined as nominal interest rate minus the inflation rate. That is:

                              Rt = it - t

Nominal interest rate (i):

The nominal interest rate does not take inflation into account. It means that, it does not adjust for the inflation rate. It is very simple concept to define, because without inflation. It can be calculated by the periodic interest rate multiplied by the number of periods per year. According to the Fisher; the nominal interest can be defined as nominal interest rate minus the inflation rate. That is:

                              it = Rt + t

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