Suppose the nominal interest rate on car loans is 9% per year, and both actual a

Question

Suppose the nominal interest rate on car loans is 9% per year, and both actual and expected inflation are equal to 5%. Complete the first row of the table by filling in the expected real interest rate and the actual real interest rate before any change in the money supply Nominal Interest Rate (Percent) Expected Inflation (Percent) Actual Inflation Percent) Expected Real Interest Rate (Percent) Actual Real Interest Rate (Percent) Time Period Before increase in MS Immediately after increase in MS Now suppose the Fed unexpectedy increases the growth rate of the money supply, causing the inflation rate to rise unexpectedly from S% to 6% per year. Complete the second row of the table by filling in the expected and actual real interest rates on car loans immediately after the increase in the money supply (MS) The unanticipated change in inflation arbitrarily benefits 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 benelits higher ieflation rate, the nominal interest rate willto per year

Explanation / Answer

Expected real interest rate = Nominal interest rate- Expected inflation rate

Now suppose the Fed unexpectedly increases the growth rate of money supply, causing the inflation rate to rise unexpectedly from 5% to 6% per year.

If inflation rises unexpectedly , in the short run borrowers and lenders will not set the nominal interest rate to reflect the increase in the inflation rate . The actual real interest rate will turn out to be different from the expected real interest rate .

Actual real interest rate = Nominal interest rate - Actual inflation rate

The unanticipated change in inflation arbitrarily benefits borrowers because unanticipated increase in inflation rate causes the actual real interest rate to be less than the expected real interest rate in the short run. Borrowers benefits from paying a lower real interest rate . And lower real interest rate harms lenders.

Now consider the long run impact of the change in money supply growth and inflation. According to the Fisher effect, as expectations adjust to the new higher inflation rate , the nominal interest rate will rise to (6% + 4%)= 10% per year.

Time period Nominal interest rate (percent) Expected inflation rate (percent) Actual inflation (Percent) Expected real interest rate (percent) Actual real interest rate (Percent) Before increase in MS 9 5 5 (9- 5)= 4 (9-5)= 4 Immdiately after increase in MS 9 5 6 (9-5)= 4 (9-6)= 3

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