Suppose John borrows $100 from Jane for one year at a fixed nominal interest rate. Suppose John and Jane both agree that the ex-ante real interest rate on the loan should be 3%.
a) What will be the nominal interest rate on the loan according to the Fisher Equation, if the expected inflation rate over the next year is:
5 percent? 3 percent? 0 percent? -2 percent? -4 percent? -6 percent?
b) If there is a zero lower bound on interest rates, what will the nominal interest rate actually be when expected inflation is equal to:
-4 percent or -6 percent?
What will the ex-ante real interest rate be in those cases?
c) Explain why deflation can be disruptive to credit markets and the economy (which is why monetary policymakers try to avoid deflation by making sure the money supply grows over time).
Suppose John borrows $100 from Jane for one year at a fixed nominal interest rate. Suppose John and Jane both agree that the ex-ante real interest rate on the loan should be 3%.
a) What will be the nominal interest rate on the loan according to the Fisher Equation, if the expected inflation rate over the next year is:
5 percent? 3 percent? 0 percent? -2 percent? -4 percent? -6 percent?
b) If there is a zero lower bound on interest rates, what will the nominal interest rate actually be when expected inflation is equal to:
-4 percent or -6 percent?
What will the ex-ante real interest rate be in those cases?
c) Explain why deflation can be disruptive to credit markets and the economy (which is why monetary policymakers try to avoid deflation by making sure the money supply grows over time).
