Suppose the nominal interest rate on savings accounts is 7% per year. If banks a

Question

Suppose the nominal interest rate on savings accounts is 7% per year. If banks and depositors expect an inflation rate of 1% per year, the expected real interest rate is 6% per year. Suppose the Federal Reserve unexpectedly increases the growth rate of the money supply, causing the inflation rate to rise unexpectedly from 1% to 3% per year. In the short run, the real interest rate on savings accounts will fall to 4% per year. The unanticipated change in inflation arbitrarily benefits epositors. Now consider the long-run impact of the change in money growth and inflation. cording to the Fisher effect, as expectations adjust to the new, higher inflation rate, the nominal interest rate will rise to 8% per year.

Explanation / Answer

1. Expected real interest Rate = Nominal Interest rate - Expected Inflation Rate = 7 - 1 = 6 per cent.

2. When inflation rate rises unexpectedly, then real interest rate will fall.

3. 7 - 3 = 4 per cent.

4. It benefits Banks as now banks will have to pay a lower real interest rate to depositors. Depositors will be worse off as they will receive money with less purchasing power as compared to its purchasing power when it was lent out and inflation rate was low.

5.Nominal interest rate will rise

6. According to Fisher, there is one to one relation between rate of inflation and rate of nominal interest rate. Inflation rate increase of 3 per cent will lead to nominal interest rate increase of 7 + 3 = 10 per cent

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