AP_Krugman_Textbook

of prices rises by 10% per year, the purchasing power of the money the bank gets back
is no more than that of the money it lent out. In effect, the bank has made a zero -
interest loan.
The expectations of borrowers and lenders about future inflation rates are normally
based on recent experience. In the late 1970s, after a decade of high inflation, borrow-
ers and lenders expected future inflation to be high. By the late 1990s, after a decade of
fairly low inflation, borrowers and lenders expected future inflation to be low. And
these changing expectations about future inflation had a strong effect on the nominal
interest rate, largely explaining why interest rates were much lower in the early years of
the twenty-first century than they were in the early 1980s.
Let’s look at how changes in the expected future rate of inflation are reflected in the
loanable funds model.
In Figure 29.6, the curves S 0 andD 0 show the supply and demand for loanable funds
given that the expected future rate of inflation is 0%. In that case, equilibrium is at E 0
and the equilibrium nominal interest rate is 4%. Because expected future inflation is
0%, the equilibrium expected real interest rate over the life of the loan, the real interest
rate expected by borrowers and lenders when the loan is contracted, is also 4%.
Now suppose that the expected future inflation rate rises to 10%. The demand
curve for funds shifts upward to D 10 : borrowers are now willing to borrow as much
at a nominal interest rate of 14% as they were previously willing to borrow at 4%.
That’s because with a 10% inflation rate, a 14% nominal interest rate corresponds to
a 4% real interest rate. Similarly, the supply curve of funds shifts upward to S 10 :
lenders require a nominal interest rate of 14% to persuade them to lend as much as
they would previously have lent at 4%. The new equilibrium is at E 10 : the result of an
expected future inflation rate of 10% is that the equilibrium nominal interest rate
rises from 4% to 14%.
This situation can be summarized as a general principle, known as the Fisher effect
(after the American economist Irving Fisher, who proposed it in 1930): the expected real
interest rate is unaffected by the change in expected future inflation.According to the Fisher ef-
fect, an increase in expected future inflation drives up nominal interest rates, where
each additional percentage point of expected future inflation drives up the nominal in-
terest rate by 1 percentage point. The central point is that both lenders and borrowers

module 29 The Market for Loanable Funds 283

Section 5 The Financial Sector

figure 29.6

The Fisher Effect

D 0 andS 0 are the demand and supply curves

for loanable funds when the expected future

inflation rate is 0%. At an expected inflation

rate of 0%, the equilibrium nominal interest

rate is 4%. An increase in expected future in-

flation pushes both the demand and supply

curves upward by 1 percentage point for every

percentage point increase in expected future

inflation. D 10 andS 10 are the demand and

supply curves for loanable funds when the ex-

pected future inflation rate is 10%. The 10

percentage point increase in expected future

inflation raises the equilibrium nominal inter-

est rate to 14%. The expected real interest

rate remains at 4%, and the equilibrium quan-

tity of loanable funds also remains unchanged.

Quantity of

loanable funds

Nominal

interest

rate

Demand for loanable funds

at 10% expected inflation

Demand for loanable funds

at 0% expected inflation

Supply of loanable funds

at 10% expected inflation

E 10

E 0

S 10

D 10

S 0

D 0

14%

4

0

Supply of loanable

funds at 0%

expected inflation

Q*

According to the Fisher effect,an

increase in expected future inflation

drives up the nominal interest rate,

leaving the expected real interest rate

unchanged.