Question 2 If borrowers and lenders expect a higher rate of inflation, (1) nominal interest rates will tend to rise. (3) real interest rates will tend to rise. (4) real interest rates will tend to fall. (3) interest rates will tend to fall. (1)

You're correct in selecting **Option (1): Nominal interest rates will tend to rise**. Here's a detailed explanation: ### **Understanding the Relationship Between Inflation and Interest Rates** 1. **Fisher Equation:** The Fisher Equation is fundamental in understanding the relationship between nominal interest rates, real interest rates, and expected inflation. It is expressed as: \[ \text{Nominal Interest Rate} = \text{Real Interest Rate} + \text{Expected Inflation} \] 2. **Impact of Higher Expected Inflation:** - **Nominal Interest Rates:** When borrowers and lenders anticipate higher inflation, lenders will demand higher nominal interest rates to compensate for the decrease in purchasing power of the money when it is repaid in the future. Similarly, borrowers are willing to accept higher nominal rates are because they expect the real value of what they repay to be lower due to inflation. - **Real Interest Rates:** Ideally, the **real interest rate** (which measures the rate of interest an investor expects to receive after allowing for inflation) remains relatively stable because any increase in the nominal rate offsets the rise in expected inflation. However, in practice, real rates can fluctuate based on various economic factors, but the primary direct impact is on nominal rates. 3. **Evaluating the Other Options:** - **Option (3) Real Interest Rates Will Tend to Rise:** This is generally **incorrect**. The real interest rate is intended to remain stable; it's the nominal rate that adjusts based on expected inflation. - **Option (4) Real Interest Rates Will Tend to Fall:** Also **incorrect** for the same reasons as above. - **Option (3) Interest Rates Will Tend to Fall:** Assuming this refers to real interest rates, it's **incorrect**. If it refers to nominal rates, it contradicts the Fisher Equation and economic expectations in a high-inflation environment. ### **Conclusion** Given the above analysis, **Option (1)** is the most accurate statement. Higher expected inflation leads to higher **nominal interest rates** as lenders seek to protect their returns against the eroding effects of inflation.