What is the nominal interest rate based on?

The nominal interest rate represents the rate of interest before adjustments for inflation. It is based on the relationship between expected inflation and the real interest rate. Specifically, the nominal interest rate is calculated by adding the expected rate of inflation to the real interest rate. The real interest rate reflects the actual purchasing power of interest earnings, while the nominal rate does not account for inflation.

When inflation is expected to rise, lenders demand a higher nominal interest rate to compensate for the decrease in the purchasing power of the money they will receive in the future. Hence, the correct choice indicates the direct relationship between expected inflation and the real interest rate, illustrating how they collectively determine the nominal interest rate. Understanding this connection is crucial for interpreting how interest rates function in the economy and their impact on borrowing and lending activities.