Question

What is the role of expectations in interest rate determination? How do expectations affect real and nominal interest rates? How and why do lenders make interest rate adjustments? How does this affect borrowers?

Answer 1

Expectations are probabilistic terms therefore the expectations cannot be mentioned with certainty and there is an element of uncertainty. The role of expectations in interest rate determination is based on the degree of uncertainty. Suppose if there is expectation of high rate of inflation in future then the nominal interest rates will be high. The real interest rates are not affected by expectations as inflation rate is not a factor in real interest rate determination. Therefore higher nominal rates in comparison of real interest rates reflect a high level of expected inflation.

The lenders make interest rate adjustments because the lending rates are based on nominal interest rates and generally they linked it with some standard lending rate like LIBOR. The expectations in interest rate affect borrowers because if the expected interest rates are high, borrowers will borrow less and if the expected interest rates are low, the borrowers will borrow more.