Why do nominal interest rates ratchet upwards with inflation?
Imagine that you are being $100 each month to perform a task, during a year with 3% inflation. In nominal dollars, your fee is constant; but in real dollars, your monthly fee is being reduced by .25% each successive month (or 3.0% divided by12 months equals .25% per month). At the end of the year, you renegotiate your fee. Your goal is to recoup your position, such that you will be paid each month with the purchasing power of the $100 paid to you in the very first month. (In essence, you have just defined your payment in real dollars, but your problem is that you are being paid in nominal dollars.) Your employer offers you a 3.0% increase in pay to $103.00 per month. While this offer seems fair on the surface, you review your payments over the last year as follows: Nominal Real Month: Payment: Payment: 1 $100.00 100.00 R$ 2 $100.00 99.75 R$ 3 $100.00 99.50 R$ 4 $100.00 99.25 R$ 5 $100.00 99.00 R$ 6 $100.00 98.75 R$ 7 $100.00 98.50 R$ 8 $100.00 98.25 R$ 9 $100.00 98.00 R$ 10 $100.00 97.
