Question

When the actual and expected (or anticipated) inflation rates are both zero, the money interest rate must equal the real interest rate. How might inflation affect the money interest rate? The nominal interest rate is determined by the forces of supply and demand in the loanable funds market (in millions of dollars).

The following calculator shows the market for loanable funds. You can shift the supply and demand curves by changing the values of the supply and demand shifters on the right. Use the calculator to help you answer the following questions. You will not be graded on any changes you make to the calculator.

If the expected inflation rate increases to 1%, then the supply of loanable funds will_____(increase/decrease) and the demand for loanable funds will _____(increase/derease) .

When the expected inflation rate is zero, the money interest rate is______(5%, 4%, 3%, 6%) . Thus, an expected inflation rate of 1% results in a money interest rate of ______(3%, 4%, 5%, 6%) and a real interest rate of _______(3%, 4%, 5%, 6%)   .

Answer 1

1. If people expect that inflation rate will increase by 1% in future then demand of loanable funds will increase today while the supply of loanable funds will decrease because lender thinks that value of their funds will decline if they lend today more.

2. When expected inflation is zero, money interest rate is 5% where demand and supply curve intersects.

3. When expected inflation is 1% then supply curve shifts leftwards and demand curve shifts rightwards and resulted in an increase in interest rate. So, money interest rate will be 6%.

4. Real interest rate = Nominal interest rate - Inflation = 6% - 1% = 5%