Explain why countries that have volatile inflation rates are likely to have high nominal interest rates.
What will be an ideal response?
You could argue that volatile inflation means the inflation rate changes, but it doesn't always mean it increases. The rate could also decrease, and then the average rate may not be that bad.So why is the nominal interest rate higher? The answer can be found in the positions of the party and counterparty to any agreement. For example, in a country where inflation is low, a change of 1 percentage point, say from 1% to 2% can benefit one party and harm the other party, but the harm/benefit is somewhat minimal. In a country where inflation may average 4% (for example), but is highly volatile, the volatility can cause the rate to change by a larger amount (more percentage points), meaning the potential harm can be much larger. To compensate for this risk, the nominal interest rates will have to be higher.
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