Answer to Question #140535 in Macroeconomics for kashif

Question

what happens to nominal interest rates if
inflation falls below what it was expected to be.

Answer 1

$\bold {Answer}$

Nominal interest rates will fall, but remains relatively high than what they are supposed to be.

$\bold {Explanation}$

Nominal interest rates are adjusted with inflationary expectations. The Fisher Effect states that:

$nominal \space interest \space rate - Expected \space inflation \space rate = Real \space interest \space rate$

Therefore,

$nominal \space interest \space rate = Expected \space inflation \space rate + Real \space interest \space rate$

Thus, when inflation falls below expectation, the inflation figure used to adjusted nominal interest rate will be higher than the actual inflation rate. As a result, nominal interest rates remain relatively high than what they are supposed to be if expected inflation equals the actual inflation.