please explain how inflation affect demand for loanable funds, and ultimately the long-term economic growth

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Expert Solution

According to the the Fisher effect , increase in expected future inflation will also increase nominal interest rate by the equal amount of expected inflation . Now the equilibrium in the market for loanable funds depends upon real interest rate . Expected inflation changes will have no effect on either real interest rate or the quantity of loanable funds available . So as per this explanation , real variables remain unaffected and quantity of loanable funds remain unchanged in long run .

But rationally thinking we can say that nominal interest rate is the price of loanable funds . So increase in inflation will cause increase in the price of loanable funds . Thus lenders will charge higher nominal interest rate incorporating the effect of inflation . So demand for loanable funds fall . Also supply of loanable funds rise because of higher nominal interest rate . This slowly brings down the interest rate in future and increases quantity of loanable funds available which boosts long term economic growth .

Rahul Sunny answered 8 months ago

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