Answer: 5%.

## Explanation The neutral rate of interest (also known as the natural rate of interest or r*) is the theoretical interest rate that neither stimulates nor restrains economic growth when the economy is at full employment and inflation is stable at the central bank's target. **Key Concept:** The neutral rate of interest is typically estimated as the sum of: 1. **Long-term real growth rate** of the economy 2. **Inflation target** of the central bank **Calculation:** - Long-term growth potential = 2% - Inflation target = 3% - Neutral rate of interest = 2% + 3% = **5%** **Why this is correct:** - The neutral rate should compensate investors for both the expected inflation (3%) and the real return on capital (2% growth potential) - At 5%, monetary policy is neither expansionary nor contractionary - If the actual interest rate is below 5%, monetary policy is expansionary (stimulating growth) - If the actual interest rate is above 5%, monetary policy is contractionary (restraining growth) **Why other options are incorrect:** - **Option A (1%):** This would be below both the inflation target and growth potential, representing highly expansionary monetary policy - **Option B (3%):** This only covers the inflation target but doesn't account for the real growth potential, making it too low for a neutral rate This concept is fundamental in monetary economics and central banking, as it helps policymakers determine whether current interest rates are stimulative, restrictive, or neutral relative to the economy's long-term potential.

Author: LeetQuiz .