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?

HINTS: Recall the Fisher relationship where (1+i) = (1+r)(1+pe), where i is the nominal interest rate, r is the required real rate of return before taxes, and pe is the expected rate of inflation.)

DLF = I + G - T + NX; I = real investment; NX = net exports

G - T = the government deficit (excess of government spending over tax revenues).

SLF = S + change in Ms - H; S = private savings; H = desired hoarding

Explanation / Answer

a)

the equilibrium rate of interest is determined by demand and supply of lonable funds where

DLF = I + G - T + NX

SLF = S + change in Ms - H

where these two curves as shown in diagrawm intersects, equilibrium interest rate is determined at i* .

b)

according to Fisher relationship (1+i) = (1+r)(1+pe)

initial situation

r= 3%

pe=4%

i={(1+r)(1+pe)} -1 = (1+ r*pe+r+pe)-1 = r*pe+r+pe =(0.03*0.04)+0.03 + 0.04= 0.0712

or i= 7.12%

If the expected rate of inflation rises to 6 percent with the real interest rate constant,

new nominal rate of interest

i* = r*pe+r+pe =(0.03*0.06)+0.03 + 0.06 =0.0918

i* = 9.18%

increase in inflatio will lead to increase in nominal interst rate by 2.06 and new i = 9.18%

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