Question

What will happen to the real interest rate during a rampant asset inflation period and then during the financial crisis triggered by the eventual bursting of the asset bubble? What will be the effect of the changes in the real interest rate on the asset inflation in the first sub-period and on the post-crisis recession in the second subperiod? (Have to ask again as the previous answer did not answer to my question at all)

Answer 1

During a rampant asset inflation period the interest rate increases as the banks curtial lending in order to increase their reserves to cover for loss to be expected from loan default when the assets realize and reach their true intrinsic value.

During a financial crisis by the eventual bursting of the bubble (like the 2009 financial crisis) demand for liquidity increases but supply of credit decreases, hence as a result it is expected that the real rate of interest will increase. But the central bank will not allow this to happen. The central bank will use monetary policy to bring demand and supply in balance and hence reduce the interest rates. Hence we will see falling interest rate in asset inflation period.

The effect of increase in interest rate in the first sub-period will lower the lending of loans from bank to businesses to finance purchases.

Whereas, the effect of decrease in interest rate in the second sub-period or post recession will lead to influx in lending and will supply loans to businesses and individuals. It will discourage saving due to the low interest rates and hence encourage both the businesses and individuals to consume more resources and invest in projects.