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Interest rates and equilibrium in loanable funds market

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7.(a) Within the loanable funds theory, graphically show the effect of an increase in the money supply, assumed to be determined solely by the Fed, on the supply and demand for loanable funds and the equilibrium rate of interest assuming a constant real rate of interest and expected inflation to be constant.

(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 2 percent. If the expected rate of inflation rises to 4 percent with the real interest rate constant, what would the resulting nominal interest rate become, using the Fisher relationship? The rise in the expected rate of inflation is considered to remain at the higher level. Define your terms and discuss a recommended monetary policy to achieve economic stabilization with price stability and an improvement in the balance of payments.

(c) Starting from an equilibrium position as in 7.a, discuss the effects of the conduct of a more restrictive monetary policy if the markets believe that a Fed tightening will lower future (next period) inflation. How might a recession occur under this scenario?

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 + Ms - H S = private savings H = desired hoarding
Ms = change in the money supply (under Federal Reserve discretionary control).

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Solution Summary

This solution addresses how shifts in supply and demand affect the interest rate in the loanable funds market model. Additionally, savings and investment are touched upon, and there is a look at the Fisher relationship and how nominal interest rate, real interest rate, and expected inflation are all interconnected.

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7. a)
Using the Fisher relationship of (1+i) = (1+r)(1+pe), it is obvious that, with a constant real interest rate and constant expected inflation, the nominal interest rate will also be constant. Given that the interest rate is constant, in both the nominal and real case, it is safe to assume that r* remains fixed in our following model. So, in that case, with an increase in money supply, Sp (in the graph attached), the r interest rate remains the same. However, the only way that the loanable funds market can remain in equilibrium is if the demand for loanable funds also rises to meet the new supply at the constant interest rate. This produces a higher quantity of loanable funds, Q*, but at a constant r* interest rate, with both supply and demand for loanable funds increased.

[See graph attached]
Reference: http://epress.anu.edu.au/apps/bookworm/view/Agenda,+Volume+16,+Number+4,+2009/5061/makin.xhtml

An increase in the expected rate of inflation will increase the nominal interest rate. Essentially, the increase in expected price level would increase the demand of loanable funds, causing the ...

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