Economists distinguish between the money rate of interest, the real rate of interest, and the “inflation premium” on a rate of interest. Explain the meaning of each of them. Suppose that in a zero price inflation situation, the money rate of interest at which demanders in the loan market may borrow money is 4 percent on a simply one-year loan. But suppose that at the end of the year when the loan is to be repaid, it is found that over the course of the year price inflation has been 3 percent. When the loan is repaid, what is the real rate of interest that the lender will receive? If it is expected that over the next year, price inflation will continue to be 3 percent, what is the nominal or money rate of interest that lenders will insist upon if they are to continue to lend money for another year? Why? Further suppose that when this next year comes to an end, price inflation turns out to have been not 3 percent, but 8 percent. What will be the real rate of interest that lenders end up earning in this situation? What does that mean?

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The money rate of interest is the rate of interest charged by lenders in the loan market The real rate of interest is the money rate of interest adjus... View the full answer