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.

  • $\begingroup$ 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. $\endgroup$ – Frank Mar 5 '20 at 5:42
  • $\begingroup$ @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. $\endgroup$ – user161005 Mar 5 '20 at 6:15
  • $\begingroup$ @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). $\endgroup$ – user161005 Mar 5 '20 at 6:19
  • 1
    $\begingroup$ 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"? $\endgroup$ – user18 Mar 5 '20 at 6:30
  • $\begingroup$ @KennyLJ Probably because in the short run wages are sticky. We're are talking about the short run here. $\endgroup$ – user161005 Mar 5 '20 at 6:32
  1. Higher price level will not lead to people spend more. You can see from AD-AS diagram that aggregate demand is downward sloping curve (see the picture below). Hence, ceteris paribus at higher price levels people spend less. So already your first link in the chain is completely incorrect. Hence no need to examine the others - if your original premise is wrong the whole logical chain breaks down.

enter image description here

  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.

PS: I personally did not downvoted this question so I can only make conjecture why others downvoted it, but I think it got downvoted because there is not much effort put into it. You could resolve this question by just googling AD-AS graph and the fisher equation. This question sounds like you are not willing to do even minimum effort in researching the topic yourself. I personally don’t downvote for that but I can understand why some people would.

  • $\begingroup$ "You could resolve this question by just googling AD-AS graph and the fisher equation" How could I google "fisher equation" if I have never heard about said equation in the first place? $\endgroup$ – user161005 Mar 5 '20 at 9:21
  • $\begingroup$ Also, I learned about the interest rate effect in this Khan academy video (youtu.be/oLhohwfwf_U?t=468 ) I just reversed the effect described. Does it mean that the video is wrong? $\endgroup$ – user161005 Mar 5 '20 at 9:25
  • $\begingroup$ @user161005 1. you obviously heard about it since you say in your question that we know nominal interest rate is equal to inflation and real interest rate. So the place where you learned this should definitely told you that this is the fisher equation and if not you can try to just put into google “nominal interest equals inflation plus real interest” and that’s literally the first search. 2. As I said I did not downvoted so please don’t focus on PS in comments here since it won’t change your point total - that’s my constructive advice so others won’t downvote your Q, take it or leave it $\endgroup$ – 1muflon1 Mar 5 '20 at 9:27
  • $\begingroup$ But what about the video? Is the video wrong or I misunderstood this part? $\endgroup$ – user161005 Mar 5 '20 at 9:34
  • $\begingroup$ @user161005 oh sorry you posted that the same time as I did my comment so I did not noticed it. Also can you please clarify what do you mean by it reversed the effect that I described? Which part of my description? I don’t think Sal says there something that would be inconsistent with what I said here. $\endgroup$ – 1muflon1 Mar 5 '20 at 9:35

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.