Questions: Money market funds are yielding almost nothing Last month, the interest rate on a money fund averaged 0.08% a year and on 5 -year CDs it was 2.6% a year. The inflation rate was 0.1% a year. USA Today, August 12, 2009 To maintain these real interest rates in the coming months, how will these nominal rates change if the inflation rate increases to 0.2 percent a year? To maintain these real interest rates in the coming months, the nominal interest rate will if the inflation rate increases to 0.2 percent a year. A. increase by 0.1 percent on the 5 -year CD and decrease by 0.1 percent on the money fund B. increase on both assets by 0.1 percent C. decrease on both assets by 0.1 percent D. increase by 0.1 percent on the money fund and decrease by 0.1 percent on the 5 -year CD E. remain constant on both assets

To determine how the nominal interest rates should change to maintain the same real interest rates when the inflation rate increases, we need to understand the relationship between nominal interest rates, real interest rates, and inflation. The real interest rate can be calculated using the formula:

\[ \text{Real Interest Rate} = \text{Nominal Interest Rate} - \text{Inflation Rate} \]

Given:

• Current nominal interest rate on the money fund = 0.08%
• Current nominal interest rate on the 5-year CD = 2.6%
• Current inflation rate = 0.1%

The real interest rates are:

• Money fund: \( 0.08\% - 0.1\% = -0.02\% \)
• 5-year CD: \( 2.6\% - 0.1\% = 2.5\% \)

If the inflation rate increases to 0.2%, to maintain the same real interest rates, the nominal interest rates must adjust as follows:

1. For the money fund:

   • New nominal rate = Real rate + New inflation rate
   • New nominal rate = \(-0.02\% + 0.2\% = 0.18\%\)

2. For the 5-year CD:

   • New nominal rate = Real rate + New inflation rate
   • New nominal rate = \(2.5\% + 0.2\% = 2.7\%\)

Thus, the nominal interest rates need to increase by 0.1% for both the money fund and the 5-year CD to maintain the same real interest rates.

The answer is B: increase on both assets by 0.1 percent.

Explanation for each option: A. Incorrect. This option suggests different changes for the two assets, which is not consistent with maintaining the same real interest rates. B. Correct. Both nominal rates need to increase by 0.1% to maintain the same real interest rates. C. Incorrect. Decreasing the nominal rates would not maintain the same real interest rates. D. Incorrect. This option suggests different changes for the two assets, which is not consistent with maintaining the same real interest rates. E. Incorrect. Keeping the nominal rates constant would not maintain the same real interest rates given the increase in inflation.