Understanding How Expected Inflation Impacts Interest Rates and Investments

If expected inflation increases, interest rates are likely to increase

Which of the following statements is CORRECT?-If expected inflation increases, interest rates are likely to increase-If individuals in general increase the percentage of their income that they save, interest rates are likely to increase-If companies have fewer good investment opportunities, interest rates are likely to increase-Interest rates on all debt securities tend to rise during recessions because recessions increase the possibility of bankruptcy, hence the riskiness of all debt securities-Interest rates on long-term bonds are more volatile than rates on short-term debt securities like T-bills

When expected inflation increases, interest rates are likely to increase because inflation reduces the value of money over time. As a result, lenders and investors would require higher interest rates to compensate for the erosion of purchasing power that occurs when inflation rises.

For example, if a lender is charging a borrower a 5% interest rate on a loan and expected inflation rises from 2% to 3%, the lender’s real return (after inflation) would decline from 3% to 2%, meaning that the lender is receiving less purchasing power in the form of interest payments. To maintain the lender’s real return, the lender may increase the interest rate to 6% to offset the inflation impact.

Similarly, in the case of bond yields, rising expected inflation would cause the prices of existing bonds to fall, as investors would demand higher yields on bonds to compensate for the potential loss of purchasing power due to inflation. Thus, when expected inflation increases, interest rates are likely to increase to maintain the real return on investment.

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