Inflation and interest rates

Abstract

One of the most pervasive effects of inflation is the associated fall in real rates of interest to negative levels. Economists have only recently emphasized the distinction between nominal and real rates of interest. If the going rate on a one year time deposit is six percent, and over the year the general price level rises by ten percent, this is equivalent to a real rate of interest of negative four percent. At the end of the year depositors would be able to purchase four percent less of goods and services than would have been possible at the beginning. Furthermore to the extent that people in the long run do not suffer from money illusion, i.e. do not feel richer when their incomes and wealth have increased by twenty percent when at the same time prices generally have increased by twenty percent, it is real and not nominal interest rates that should be relevant to their behavior.