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There is persistent fear that there will be a high level of deflation. Many economists warn that it may be worse for the economy if there is high inflation. Let's work through one example. Suppose that Herb is in debt and has to pay a 4.25% nominal interest rate. He expected inflation to be 1.00%. Instead, inflation is -1.00% (deflation).
1. What is the real interest rate that Herb expected to pay? Write your number out to 2 decimal places (for example, 1.11, not just 1) _________%
2.What is the real interest rate that Herb will in fact pay? Write your number out to 2 decimal places (for example, 1.11, not just 1) _________%
3). When there is deflation, as in inflation of -1%, the real interest rate that Herb pays (as compared to what he expected to pay): increases, so Herb feels poorer decreases, so Herb feels richer increases, so Herb feels richer decreases, so Herb feels poorer.
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