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Questions › GATE › GATE 2023 › Q53
2 marksMacroeconomics › Demand for money and monetary theories › Real and nominal interest rates, and seigniorageModerateabout 2 min

GATE 2023 Question 53: Demand for money and monetary theories

Let πe\pi^eπe be the expected inflation rate, iii be the nominal interest rate and rrr be the real interest rate. Which of the following statements is/are correct?

Select all that apply.

Answer and worked solution

Answer: (A) and (B) and (C)

(A) is correct: the Fisher equation states 1+i=(1+r)(1+πe)1+i = (1+r)(1+\pi^e)1+i=(1+r)(1+πe) exactly, which for small values of rrr and πe\pi^eπe approximates to r≈i−πer \approx i - \pi^er≈i−πe (the cross-term rπer\pi^erπe becomes negligible).

(B) is correct: a low real interest rate means borrowing is cheap in real terms (incentivizing more borrowing) and lending yields little real return (disincentivizing lending) — standard behavioral implication of the real rate.

(C) is correct: the real interest rate, by construction, strips out inflation to reflect the true purchasing-power cost of borrowing, which is exactly why it (not the nominal rate) is the economically relevant cost for real decision-making.

(D) is incorrect: using the Fisher approximation, r≈i−πe=8%−10%=−2%r \approx i - \pi^e = 8\% - 10\% = -2\%r≈i−πe=8%−10%=−2%, a negative 2%, not positive 2% as stated — the sign is flipped in this option.

Therefore the correct statements are (A), (B), and (C).

The trap: A;B;C;D

(D) requires actually plugging in the numbers rather than accepting the statement's framing at face value — students confident in the general Fisher relationship from (A) may not bother re-verifying (D)'s specific arithmetic and accept its claimed '+2%' without noticing 8−10=−28-10=-28−10=−2, not +2+2+2.

Plain-text version

Let π^e be the expected inflation rate, i be the nominal interest rate and r be the real interest rate. Which of the following statements is/are correct? (A) For small values of r and π^e, r ≈ i-π^e. (B) When real interest rate is low, there are greater incentives to borrow and fewer incentives to lend. (C) Real interest rate reflects the real cost of borrowing. (D) If i=8% and π^e=10%, then r is approximately (+) 2%.

Also written as: Let pi^e be the expected inflation rate, i be the nominal interest rate and r be the real interest rate. Which of the following statements is/are correct?

Demand for money and monetary theories has come up 82 times in 7 exams since 2005.

What this question tests

This question is on Real and nominal interest rates, and seigniorage, part of Demand for money and monetary theories in Macroeconomics.

How inflation separates real from nominal returns, and the revenue the government earns by printing money.

TestStop has 16 past-paper questions on this subtopic.

Take this paper as a timed mockMore on Real and nominal interest rates, and seigniorage

Question from the GATE 2023 paper. Solutions are TestStop's own. Not affiliated with or endorsed by any examination authority.