Major Determinants of Interest Rates: Inflation Expectations

Major Determinants of Interest Rates
We have seen that a multitude of forces can initiate shifts in the supply of or demand for loanable funds, thereby triggering changes in interest rates. Four particularly important forces are inflation expectations, Federal Reserve policy, the business cycle, and federal budget deficits.

Inflation Expectations
The level of interest rates strongly tends to rise in periods in which the expected rate of inflation increases. Interest rates typically fall when expected inflation declines. The loanable funds framework can explain this phenomenon. Suppose that inflation has been relatively subdued for several years approximately 3 percent per year for the past decade. Given this environment, the supply and demand curves for loanable funds are represented by S’Lf and D]LF in Figure 5-3, with equilibrium at A. The equilibrium interest rate is /’j.

Now suppose that the inflation rate escalates to around 6 percent per year and the public comes to expect this higher rate of inflation to continue for some time. Given this event, we will demonstrate that the supply curve of loanable funds shifts leftward, the demand curves shifts rightward, and the equilibrium interest rate increases.

The development of prospects for continuing inflation of 6 percent reduces the supply of loanable funds, shifting the supply curve leftward from SlLF to Sjjr. At each and every interest rate, the willingness to lend money is reduced because the real value of the principal is expected to erode more rapidly. Lenders reconsider the alternatives to lending. Some former lenders may elect instead to purchase common stocks, gold and other precious metals, real estate, or other real assets that are believed to be more effective hedges against inflation than debt instruments. For these reasons, the supply of loanable funds decreases (shifts leftward). At any given interest rate, lending is less attractive now that expected inflation has increased.

At the same time, the increase in expected inflation raises the demand for loanable funds. At each and every interest rate, the willingness to borrow is stimulated, shifting the demand curve rightward from D’LF to D\f. This follows from the fact that the price, or nominal value, of goods or assets purchased with borrowed funds is expected to rise with inflation while the nominal value of the principal borrowed is not. Alternatively stated, the real value of the projects built or goods purchased with borrowed funds remains constant during inflation, while the real burden of the debt incurred is reduced. Therefore an increase in expected inflation tends to increase the rate of homebuilding activity, household credit purchases, and investment in plant, equipment, and inventories at each possible interest rate. The demand curve for loanable funds in Figure 5-3 shifts rightward when expected inflation increases.

Given the reduction in supply and the increase in demand for loanable funds induced by the increase in expected inflation, the equilibrium moves to B in the figure. The equilibrium price of loanable funds the interest rate rises. Assuming the existence of competitive financial markets unrestricted by controls, the interest rate in Figure 5-3 rises from ii to i2. The effect that a change in expected inflation exerts on the level of interest rates is known as the Fisher effect, named for the great American economist, Irving Fisher, who pioneered the theory linking interest rates and expected inflation.

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