If the expected inflation rate increases to 2%, then the supply of loanable fund
ID: 2443232 • Letter: I
Question
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%).
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 0 Graph Input Tool Interest Rate (Percent) Supp uantity demanded Millions of dollars) 250 %uantity supplied 250 Millions of dollars) Demand Shifter Supply Shifter Expected Inflation (percent) 8 Expected Inflationn (percent) mand 100 200 300 400 500 LOANABLE FUNDS (Millions of dollars)Explanation / Answer
Solution :
Money interest rate = real interest rate + expected inflation
So, when expected inflation = 0, money interest rate = real interest rate = 10% in this example.
Now, when expected inflation rate increases to 2% (from 0%), it means for a constant money inflation rate, real interest rate must have decreased, as a result of which the demand for loanble funds increase (since now the borrowing has become cheaper, as lower amount is returned on borrowing) and supply of loanble funds decrease (since, the lending has become expensive now, as lower returns are earned on lending).
We already saw that with 0 inflation rate, money interest rate is 10%. So, now demand for loanable funds curve shift upwards, and supply of loanable funds curve also shift upwards (both shifts by amount of inflation.), finally resulting in a higher market interest rate even with the same real interest rate, i.e, real interest rate = 10%
market interest rate = expected inflation + real interest rate = 2 + 10 = 12%