Answer to Question #233923 in Macroeconomics for Violet

Question

Carefully show how expected inflation determines interest rates per the loanable funds theory. (6marks)

Answer 1

The demand schedule for loanable funds is constructed based on the price of the funds. Expected inflation magnitudes, assuming they have an effect, will modify the entire demand timetable. If predicted inflation rises, potential lenders are likely to increase current consumption, lowering available funds: the supply schedule swings upwards. Because the real interest rate "should" remain constant, these changes will result in an increase in the equilibrium nominal interest rate, which will be equal to the increase in predicted inflation. The total number of loans in the system will remain unchanged (and so real magnitudes like consumption will be unaffected).