Question

F. Describe (you must provide a drawing with axes labeled and equilibrium identified along with a short explanation) what happens to the equilibrium interest rate when: (i) inflation is expected to decrease (3 Points) (ii) the stock market crashes (3 Points) (iii) government deficit goes down (3 Points) (iv) money supply decreases (3 Points)

Answer 1

Rate of interest :

The rate of interest often tells about the amount that has to be earned if invested or has to be given if borrowed over and above the principle amount

i) with the inflation expected to fall , the interest rate will fall as with lesser price the quantity demanded for borrowings will rise so as inflation and rate of interest. As in order to control high inflation rate of interest is increased reducing the borrowing however will low inflation rate of interest will low from R to R1 making equibirium from E to E1 rising borrowing from Q to Q 1

ii) With the crash or fall in stock market the rate of interest will rise as the total demand of share market will fall. Increasing the interest from R to R1 and shifting equibirium higher from E to E1 however reducing the demand to invest in stock market from Q to Q1

iii) when government deficit falls the IS curve will shift to left ,no moving the LM curve i.e. reducing the interest with government deficit from R to R1 and Y to Y1 respectively ,and also equilibrium goes down from E to E1

iv) as money supply falls the supply curve shift to right making fall in quantity from Q to Q1 however it will rise the interest from R to R1 ,also shifting the equibirium up from E to E1

Conclusion:

Interest rate has different relations with different factors which actually bring change in the overall human behaviour in the market

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