Question

10. Using the accompanying diagram, explain what will happen to the market for loanable funds when there is a fall of 2 percentage points in the expected future inflation rate. How will the change in the expected future inflation rate affect the equilibrium quantity of loanable funds? Interest rate 1 - 8% E1 F.... Q1 Quantity of loanable funds 11. Then

Answer 1

The decision to invest or save depends on the real interest rate of the economy. The real interest rate is given by Fischer's equation as Real Interest rate = Nominal interest rate - expected inflation The savers increase savings at each interest rate if interest if the real interest increases and the investors decreases demand for loan if the real interest increases. Then if expected inflation falls the real interest rate rises. Then the supply of funds rises and the demand for funds decreases at the same time. This keeps the amount of funds at the equilibrium unchanged but decreases nominal interest rate by the fall in expected inflation. This is depicted in the figure below. Interest rate S1 118% E1 . ... Quantity of loanable funds In this case the initial real and nominal interest rate was 8%. As expected inflation falls by 2%, the real interest falls by 2% to 6%. As interest rate falls, the borrowers are willing to borrow as much as they were at the real interest rate of 8%. This decreases nominal interest rate willing to borrow by 2% at every unit of funds. Similarly, the lenders are willing to receive as much as 8% for each unit of funds, thus they increase supply of funds such that every unit now earns 8% nominal interest rate. At equilibrium the nominal interest falls to 6% while the quantity of loans remains unchanged.