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Deflation: Real Interest Rates

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1. What would happen to real short term interest rates if the economy is going through a global deflationary period?

2. Relative to Fama's Efficient Market Hypothesis, which of the following markets is the most efficient: equity, debt, or foreign exchange?

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This solution explains the changes in real interest rates during deflation. The sources used are also included in the solution.

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The real short term interest rates will decline if the economy is going through a deflationary period (a). First, deflation occurs if there is fall in aggregate demand. Fall in aggregate demand leads to lower demand for capital from businesses and this depresses real interest rates (b). Second, during deflationary period investment falls and this reduces the demand for loans and debt reducing real interest rates. Third, during deflationary period the central bank or the Federal Reserve reduces real ...

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