Economica's Nominal and Real Interest Rates: Causes and Implications

Possible Causes for Economica's Interest Rate Situation

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Question

In year 1, the nation of Economica has no government debt, production is at potential, the nominal interest rate is 8.6% and the real rate is 5.2%. In year 2, the nominal rate is 11.1% and the real rate is 6.7%. Which of the following would be most likely to cause such a situation?

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A. B. C. D. E.

A

In this case, the real rate has increased, as well as the rate of inflation. This is most likely to be caused by a budget deficit. Deficit spending causes the real rate to rise due to government demand for debt. Inflation would also increase because government spending amounts to an increase in aggregate demand, which would shift the price level higher.

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