Page 325 - Krugmans Economics for AP Text Book_Neat

of prices rises by 10% per year, the purchasing power of the money the bank gets back
According to the Fisher effect, an
is no more than that of the money it lent out. In effect, the bank has made a zero -
increase in expected future inflation
interest loan.
drives up the nominal interest rate,
The expectations of borrowers and lenders about future inflation rates are normally leaving the expected real interest rate
based on recent experience. In the late 1970s, after a decade of high inflation, borrow- unchanged.
ers and lenders expected future inflation to be high. By the late 1990s, after a decade of Section 5 The Financial Sector
fairly low inflation, borrowers and lenders expected future inflation to be low. And
these changing expectations about future inflation had a strong effect on the nominal
interest rate, largely explaining why interest rates were much lower in the early years of
the twenty-first century than they were in the early 1980s.
Let’s look at how changes in the expected future rate of inflation are reflected in the
loanable funds model.
In Figure 29.6, the curves S 0 and D 0 show the supply and demand for loanable funds
given that the expected future rate of inflation is 0%. In that case, equilibrium is at E 0
and the equilibrium nominal interest rate is 4%. Because expected future inflation is
0%, the equilibrium expected real interest rate over the life of the loan, the real interest
rate expected by borrowers and lenders when the loan is contracted, is also 4%.
Now suppose that the expected future inflation rate rises to 10%. The demand
curve for funds shifts upward to D 10 : borrowers are now willing to borrow as much
at a nominal interest rate of 14% as they were previously willing to borrow at 4%.
That’s because with a 10% inflation rate, a 14% nominal interest rate corresponds to
a 4% real interest rate. Similarly, the supply curve of funds shifts upward to S 10 :
lenders require a nominal interest rate of 14% to persuade them to lend as much as
they would previously have lent at 4%. The new equilibrium is at E 10 : the result of an
expected future inflation rate of 10% is that the equilibrium nominal interest rate
rises from 4% to 14%.
This situation can be summarized as a general principle, known as the Fisher effect
(after the American economist Irving Fisher, who proposed it in 1930): the expected real
interest rate is unaffected by the change in expected future inflation. According to the Fisher ef-
fect, an increase in expected future inflation drives up nominal interest rates, where
each additional percentage point of expected future inflation drives up the nominal in-
terest rate by 1 percentage point. The central point is that both lenders and borrowers

figure 29.6

The Fisher Effect Nominal
interest
D 0 and S 0 are the demand and supply curves rate Demand for loanable funds Supply of loanable funds
for loanable funds when the expected future at 10% expected inflation at 10% expected inflation
inflation rate is 0%. At an expected inflation
rate of 0%, the equilibrium nominal interest
S 10
rate is 4%. An increase in expected future in-
E 10
flation pushes both the demand and supply 14%
curves upward by 1 percentage point for every
percentage point increase in expected future
Demand for loanable funds Supply of loanable D 10
inflation. D 10 and S 10 are the demand and
at 0% expected inflation funds at 0%
supply curves for loanable funds when the ex- expected inflation S
pected future inflation rate is 10%. The 10 0
percentage point increase in expected future
4
inflation raises the equilibrium nominal inter-
E 0
est rate to 14%. The expected real interest
rate remains at 4%, and the equilibrium quan- D 0
tity of loanable funds also remains unchanged.
0 Q* Quantity of
loanable funds

module 29 The Market for Loanable Funds 283