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 2%, then the supply of loanable funds will (increase, decrease) and the demand for loanable funds will (increase, decrease).

When the expected inflation rate is zero, the money interest rate is (12%, 10%, 8%, 6%). Thus, an expected inflation rate of 2% results in a money interest rate of(12%, 10%, 8%, 6%) and a real interest rate of(12%, 10%, 8%, 6%).

Answer 1

If the expected inflation rate increases by \(2 \%\), then the supply of loanable funds will decrease and the demand for loanable funds will increase.

When the expected inflation rate is zero, the money interest rate is \(\mathbf{1 0 \%}\), (as it is the equilibrium rate where the supply and demand are equal).

When the expected inflation rate is \(2 \%\), there will a leftward shift in the supply curve and the demand curve shifts rightwards, that leads to an increase in the interest rates.

Thus, the money interest rate will be \(12 \%\).

Calculate the real interest rate as follows:

Real interest rate \(=\) Nominal interest rate \(-\) Inflation

$$ \begin{array}{l} =12 \%-2 \% \\ =10 \% \end{array} $$

Thus, the real interest rate is \(10 \%\).