Question

In a different scenario, suppose that the demand and supply curves for loanable funds shown on the following graph occur when the expected future inflation rate is 5%. Then, a sudden shock to the economy causes the expected future inflation rate to rise to 9.6%. Assuming the Fisher effect holds, show the impact that this will have on the loanable funds market by shifting one or both curves on the following graph Tool tip: Click and drag one or both of the curves. Curves will snap into position, so if you try to move the curve and it snaps back to its original position, just try again and drag it a little farther. NOMINAL INTEREST RATE !Percent) 24 + 20- S5 16 D5 QUANTITY OF LOANABLE FUNDS According to the Fisher effect, a decrease in expected future inflation causes a decrease n the nominal interest rate, and in the expected real interest rate.

Answer 1

When there is an increase in expected future inflation rate , nominal interest rate may increase or remain constant . Now , real interest rate = Nominal interest rate - expected inflation rate . Thus , as expected inflation rate increases real interest rate decreases considering nominal interest rate remains the same. If nominal interest rate increases at the same rate as expected inflation rate, real interest will remain constant. If there is increase in expected nominal rate there is a decrease in real interest rate. As a result , supply of loanable funds shift to the left. As such, there is a decrease in the quantity of loanable funds. The changes are shown in the diagram below. Here, the equilibrium has shifted from point a to b. In the diagram the new supply curve S9.6 has shifted parallelly upwards with a vertical distance of 9.6-5 = 4.6 magnitude.

According to the Fisher effect, a decrease in expected future inflation causes a decrease in the nominal interest rate , and increase in the expected real interest rate.