Question

a)Explain why a predictable rate of inflation makes real interest rates more predictable. b) Explain why unpredictable real interest rates hamper real economic investment.

Answer 1

a) In general, as interest rates are reduced, more people are able to borrow more money. The result is consumers have more money to spend causing the economy to grow and inflation to increase. The opposite holds true for rising interest rates. As interest rates are increased, consumers tend to save as returns from savings are higher. With less disposable income being spent as a result of the increase in the interest rate, the economy slows and inflation decreases. Hence, there exists an inverse relationship between inflation and interest rate which implies predictable rate of inflation makes real interest rates more predictable.

b) The unpredictable real interest rates hampers real economic investment because both are inversely related. Higher interest rates reduce investment because higher rates increase the cost of borrowing and require investment to have a higher rate of return to be profitable. Similarly, with lower interest rates investment will rise.