# How to reconcile fact that “real interest=nominal interest - inflation” with prediction of the interest rate theory about expensivity of loans?

According to the interest rate theory higher price level will lead to following chain of events in the short run: Marginal propensity to save will decrease(ratio of spending/saving will change, people will spend relatively more compared with saving) => savings will decrease => less money will become available for lending => the interest rate will increase => firms will spend less because loans became more expensive. Or in other words, higher price level => more expensive loans for firms.

BUT, we also know that the real interest rate equals the nominal interest rate minus the inflation rate. Higher inflation would decrease the real interest rate. Wouldn't lower real interest rate make borrowing money less expensive for firms?

P.S. Why is my question being downvoted? Please, provide feedback so I could improve it. I can't read minds.

• I don't see how a decrease in savings can have any effect on lending at all. Fractional reserve requirements these days are typically 0%. Also, higher prices would mean people borrow more and therefore spend more. – Frank Mar 5 '20 at 5:42
• @Frank And I don't understand why you don't see connection and I don't understand how low fractional reserve requirement will help banks to preserve amount of money available for lending. Imagine extreme case scenario: Nominal prices skyrocketed and now all household have to spend everything they earn, with literally zero savings. Banks just wouldn't have money to lend, even if their fractional reserve requirement was strictly equal to zero. – user161005 Mar 5 '20 at 6:15
• @Frank "Also, higher prices would mean people borrow more" I don't see how it follows in all possible cases (like when the government is printing money). – user161005 Mar 5 '20 at 6:19
• I'll stop you at the very first link in your chain of events: Why does "higher price level" lead to "People will spend more and save less"? – user18 Mar 5 '20 at 6:30
• @KennyLJ Probably because in the short run wages are sticky. We're are talking about the short run here. – user161005 Mar 5 '20 at 6:32

1. The fisher equation $$i= \pi+r$$, where $$\pi$$ is inflation $$i$$ nominal interest rate and $$r$$ real interest rate, can indeed be rearranged as $$i-\pi=r$$ but that does not mean the inflation necessarily leads to lower real interest - this is not some sort of relationship where $$i$$ and $$\pi$$ are exogenously exerting influence on $$r$$. This is endogenous system, you can as well keep it in its original form $$i=\pi+r$$ and conclude that just $$i$$ increases to compensate for increasing inflation. In fact that’s most often the case because real interest rates are (at least in short run) the least flexible of the three variables in the fisher equation. But in general you can’t say higher inflation leads to higher real interest rate.