Question

1. Please explain, in detail, the following:

a. What is the Fisher effect? Write it out in a mathematical expression and illustrate using supply and demand analysis.

b. Using supply and demand for loanable funds framework, identify FOUR reasons why interest rates have been low in recent years.

Answer 1

A) Fisher effect is an equation which shows the relationship between the real rate of interest and nominal rate of interest.

The mathematical equation is:

Real rate of Interest=Nominal rate of Interest-Inflation in the economy of the country

So, if the demand for the product in the market is more as compared to supply the inflation will rise in the country to automatically reduce the demand for the product.

Now if the supply is more than demand in the market than to increase the demand in the market the rates(Inflation) of the product will decrease and in turn increase the real interest rate in the market.

B) Four reasons why interest rates are low:

1) Recently governments are adopting the expansion policies in the economy due to which they want to increase the supply of money in the market and due to it they want to reduce interest rate in the market.

2) Due to increase in inflation in recent years the real interest rate has decreased drastically even though the nominal rate of Interest has increased

3) After the financial crisis in 2008 and European crisis, all major economies are adopting expansion policy to recover economy back to growth path due to which they have to reduce the interest rate in the market.

4) As the rate of risk-free return is decreasing in the market the bond yield has also decreased in the market which led to the lower interest rate in the market.