1. -10 percent.
2. 10 percent.
3. 6 percent.
4. -6 percent.
Choose the correct option.
Option 2 is correct. The realized real interest rate equals the nominal interest rate minus the rate of inflation. If the nominal interest rate is 8 percent and the rate of inflation is 10 percent the realized rate of interest is therefore -2 percent.
Let τ be the actual inflation rate and r be the nominal interest rate. Then the realized real interest rate equals
rr = r - τ so τ = r - rr.
It follows that 8 - (-2) = 8 + 2 = 10.
An inflation rate of 10 percent reduces the real value of a sum to be paid back at the end of the year by 10 percent. Nominal interest at 8 percent increases the amount to be received at the end of the year by 8 percent. The net effect is (approximately) a reduction in the real amount to be received by 2 percent.