Using the graph below of the supply of loanable funds, SLF, and the demand for l

Question

Using the graph below of the supply of loanable funds, SLF, and the demand for loanable funds, DLF, discuss the following:

a. What is meant by the equilibrium rate of interest ?

b. Illustrate and discuss how an autonomous increase in the expected rate of inflation will change the equilibrium nominal interest rate. Consider an initial real rate of interest of 3 percent and an expected inflation rate of 4 percent. If the expected rate of inflation rises to 6 percent with the real interest rate constant, what would the resulting nominal interest rate become, using the Fisher relationship?

Explanation / Answer

a. The interest rate at which the supply for money meets its demand. In our graph, it is the intersection point of Dlf and Slf, where both demand for loanable funds equals the supply of loanable funds. The equilibrium rate of interest is used by central banks as a means of managing money supply.

b. The Fisher effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate. Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation.

we can say, Nominal interest rate = real interest rate + expected inflation

Considering an initial real rate of interest of 3 percent and an expected inflation rate of 4 percent.

Nominal interest rate = 3% + 4% that is 7%

now, If the expected rate of inflation rises to 6 percent with the real interest rate constant, we can re-write the equation as below;

Resulting nominal interest rate = 3% + 6% = 9%

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