Interest Rate Determination

Answer the following Questions:

1. What is the difference between the nominal interest rate and real
interest rate?

The nominal interest rate: is the interest rate that is explicitly stated in a loan
agreement or investment. It represents the percentage of interest that is
charged or earned on a financial instrument without considering the effects
of inflation or other factors. The nominal interest rate is typically expressed
on an annual basis.

Real interest rate: takes into account the impact of inflation on the
purchasing power of money. It represents the rate of return adjusted for
inflation, which reflects the actual increase in purchasing power of an
investment or the actual cost of borrowing after considering inflation. The
real interest rate is usually lower than the nominal interest rate because it
accounts for the erosion of value due to inflation.

2. What is the logic behind the Fisher effect’s implied positive relationship
between expected inflation and nominal interest rates?

The logic behind this relationship is based on the idea that lenders and
investors require compensation for the erosion of purchasing power caused
by inflation.

3. Impact of Exchange Rates on Interest Rates. Assume that if the U.S.

dollar strengthens, it can place downward pressure on U.S. inflation. Based
on this information, how might expectations of a strong dollar affect the
demand for loanable funds in the United States and U.S. interest rates? Is
there any reason to think that expectations of a strong dollar could also affect
the supply of loanable funds? Explain.

A strong currency such U.S dollar can lower interest rates because it can
decrease the demand for loanable funds and hence reduce U.S. inflation. The
 expectations of a strong dollar could also increase the supply of funds
because it may encourage saving (there is less concern to purchase goods
before prices rise when inflationary expectations are reduced). In addition,
foreign investors may invest more funds in the United States if they expect
the dollar to strengthen, because that could increase their return on
investment.

4. Impact of Government Spending. If the federal government planned to

expand the space program, how might this affect interest rates?

An expanded space program would impose the federal government to

increase its budget deficit. And possibly impose any firms involved in
facilitating the program to borrow more funds. There is consequently a
higher need for loanable funds. Higher income and more saving could result
from the increased spending. However Yet, this impact is not likely to be as
great. The likely overall impact would therefore be upward pressure on
interest rates.

5. Impact of Economic Crises on Interest Rates. When economic crises in

countries are due to a weak economy, local interest rates tend to be very low.
However, if the crisis was caused by an unusually high rate of inflation,
interest rates tend to be very high. Explain why.

The demand for loanable funds declines when the economy is weak.
because corporations reduce their expansion plans as they anticipate a
reduced demand for their products. The reduced demand for loanable funds
results in lower interest rates. However, if a crisis is caused by high
inflation, corporations and households engage in heavy borrowing and
spending before prices rise further. Thus, the strong demand for loanable
funds places upward pressure on interest rates
6. Global Interaction of Interest Rates. Why might you expect interest rate
movements of various industrialized countries to be more highly correlated
in recent years than in earlier years?

Because financial markets have become increasingly globally interconnected

in recent years, interest rates are anticipated to be more heavily associated
between nations. More international financial flows will occur to capitalize
on higher interest rates in foreign countries, which affects the supply and
demand conditions in each market. As funds leave a country with low
interest rates, this places upward pressure on that country's interest rates.
The international flow of funds caused this type of reaction.