The fisher effect and the cost of unexpected inflation Suppose the nominal Inter

Question

The fisher effect and the cost of unexpected inflation Suppose the nominal Interest rate on car loans is 11 percentage per year. If borrowers and lenders expect an Inflation rate of 2 percentage per year, the expected real interest rate is per year. Suppose the Federal Reserve unexpectedly Increases the growth rate of the money supply, causing the inflation rate to rise unexpectedly from 2 percentage to 6 percentage per year. In the short run, the real interest rate on car loans will to per year. The unanticipated change In Inflation arbitrarily harms. Now consider the long-run impact of the change In money growth and Inflation. According to the Fisher effect, as expectations adjust to the new, higher inflation rate, the nominal interest rate will to per year.

Explanation / Answer

1) Fisher equation gives us the value of real interest rate. If i is nominal interest rate and f is inflation then real interest rate r is given by

r = ((1+i ) / ( 1+f )) - 1

We can also solve this approximately

r = i - f

Now in the above example, i = 11% and inflation is given as 2%

((1.11) / (1.02 )) -1 = 8.8%

or approximately 9%.

2) Now inflation has turned out to be 6%

(( 1.11 ) / ( 1.06 )) - 1 = 4.7%

approximately 5%.

This increase in inflation will lead to decrease in real interest rate and that will hurt the lender but will be good for borrower.

3) To maintain the same level of real ineterest rate, nominal rates will have to increase to 15% approximately.

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