Question

11. Using the notions of ex ante and ex post interest rates, explain how a bank could be expecting a huge return on its investments and end up with very small real returns.

Answer 1

Ex-ante = Nominal Interest Rate – Expected Inflation

Ex-ante r =

Actual inflation = Ex-post = Nominal Interest Rate – Actual Inflation

Ex-post r =

From a macroeconomic perspective, why is deflation so bad? Please refer to consumer behavior and the corresponding behavior of firms in a deflationary environment. Please explain completely.

Now discuss the fact that persistent deflation is the central bank's worst nightmare? Why is this environment such a nightmare for the central bank and monetary policy? Explain using the Fisher equation for the real rate of interest and refer to both the ex-post and ex-ante real rate of interest.

Deflation is essentially opposite of inflation. It Causes the price to general goods to go down after a recession. That leads to delayed spending, nominal wage cuts and higher burden to debt ratio. Whenever there is deflation the people tend to save more and firms don’t want to borrow because of higher interest rate. This leads to less spending and less money is invested into expansion of businesses as it is expensive to lend for the firms and since people are not spending anyway, it is of no use to the firms to expand.

Real Interest Rate = Nominal Interest Rate – Inflation

Ex-Post – Because the inflation is negative as there is deflation, the real interest rate tends to be higher than the nominal interest rates. Thus is beneficial for the consumers to save more as their purchasing power would increases if they save. For Firms, they don’t want to lend because of high interest rates and consumers are not willing to buy their goods anyway as they are saving. Thus the firms tend not to adopt expansionary policy by lending.

Ex-Ante – In this same concept is applied except that it is expected. The expected real interest rate is high, thus consumers tend to save and firms tend not to borrow. This leads to a high burden to debt ratio and thus becomes a nightmare for central banks to handle it.