Suppose the nominal interest rate on car loans is 11% per year. If borrowers and

Question

Suppose the nominal interest rate on car loans is 11% per year. If borrowers and lenders expect an inflation rate of 2 % per year, the expected real interest rate is [ ? ] per year Suppose the Fed unexpectedly increases the growth rate of the money supply, causing the inflation rate to rise unexpected from 2 % to 6 % per year. In the short run, the real interest rate on car loans will (rise/fall) to [ ? ] per year. The unanticipated change in inflation arbitrarily harms (borrowers/lenders) 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 (rise/fall) to [ ? ] per year.

Explanation / Answer

i = r + p* r = i – p* i = nominal rate of interest r = real rate of interest p* = expected inflation rate r= 11-2=9% if it increases from 2% to 6% the real interest rate will fall higher inflation rate, the nominal interest rate will rise from above fisher equations

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