Question 6 Chapter 17 The Fisher effect and the cost of unexpected inflation
6. The Fisher effect and the cost of unexpected inflation
Suppose the
... [Show More] nominal interest rate on car loans is 11% per year, and both actual and expected inflation are equal
to 4%.
Complete the first row of the table by filling in the expected real interest rate and the actual real interest rate
before any change in the money supply.
Time Period
Nominal
Interest Rate
(Percent)
Expected
Inflation
(Percent)
Actual
Inflation
(Percent)
Expected Real
Interest Rate
(Percent)
Actual Real
Interest Rate
(Percent)
Before increase in 11 4 4 7 7
MS
Immediately after 11 4 6 7 5
increase in MS
Points: 1 / 1
Now suppose the Fed unexpectedly increases the growth rate of the money supply, causing the inflation rate to
rise unexpectedly from 4% to 6% per year.
Complete the second row of the table by filling in the expected and actual real interest rates on car loans
immediately after the increase in the money supply (MS).
The unanticipated change in inflation arbitrarily benefits .
Points: 1 / 1
Explanation: Close Explanation
The real interest rate adjusts the nominal interest rate (11%) for the rate of inflation and equals the
nominal rate minus the inflation rate. The real interest rate also reflects the change in purchasing power the
lender receives for lending money to the borrower. In this case, borrowers and lenders anticipate an inflation
rate of 4%, so the expected real interest rate is calculated as follows:
u13%st to t
Now consider the long-run impact of the change in money growth and inflation. According to the Fisher effect, as
expectations adj
15%
he new, higher inflation rate, the nominal interest rate will rise to
per year.
Points: 0.5 / 1
Explanation: Close Explanation
The Fisher effect describes the long-run behavior of nominal interest rates and inflation based on monetary
neutrality—the notion that monetary changes are irrelevant for real variables in the long run. In the long
run, borrowers and lenders will agree to a new nominal interest rate as their expectations of inflation adjust.
In this particular case, the long-run real interest rate will be the sum of the nominal interest rate of 11%
and the change in the inflation rate, which is :
In other words, the 2-percentage-point increase in inflation will be reflected in a 2-percentage-point increase
in the long-run nominal interest rate. Note that this results in no change in the long-run real interest rate.
The long-run real interest rate will not be affected by an increase in the growth rate of money and inflation.
If inflation rises unexpectedly, in the short run borrowers and lenders will not set the nominal interest rate
to reflect the increase in the inflation rate. The actual real interest rate will, therefore, turn out to be
different from the expected real interest rate. In this case, inflation rises unexpectedly from 4% to 6%.
The unexpected increase in the inflation rate causes the actual real interest rate to be less than the
expected real interest rate in the short run. The borrowers benefit from paying a lower real interest rate.
The lower real interest rate harms lenders, who now receive a smaller-than-expected increase in purchasing
power in return for the funds they lend to borrowers. [Show Less]