Unformatted text preview: the price level. Expectations Effect: the expected inflation rate. • • • • Anything that affects either the supply of loanable funds or the demand for loanable funds will obviously affect the interest rate. This happens in 4 ways:
• • Liquidity effect: Change in roi because of a change in supply of loanable funds Income effect: When real GDP rises, demand for loanable funds rises more than the supply of loanable funds which leads to a rise in roi Price level effect: Price increase leads to a fall in purchasing power. The demand for loanable funds may increase which causes a rise in roi Expectations effect: When expected inflation rises, demand for loanable funds increases but supply decreases. Thus roi rises • • Expectations Effect
If inflation is expected to increase
• Households may reduce their savings to make purchases before prices rise • Supply shifts to the left, raising the equilibrium rate • Also, households and businesses may borrow more to purchase goods before prices increase • Demand shifts outward, raising the equilibrium rate Diagrammatically…… The Nominal and Real Interest Rates
• Nominal interest rate: the interest rate actually charged (or paid) in the market; the market interest rate. • The Real Interest Rate: the Nominal Interest Rate minus the Expected Inflation Rate. these reflect the real cost of borrowing or the actual cost of borrowing, this factors in the inflation. this was made in an equation called the fishe equation it is nominal interest rates - exp inflation, real interest rates = nominal interest / p, look at wills notes. the expectation effect or the fis effect, the effect on real interest rate is that it goes down so people dema more loanable funds, and the lender doesnt want to lend because he gets less he gets less in return for his loan....
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