Chapter 2

Determination of Interest Rates

3. Impact of Government Spending. If the federal government planned to expand the space program, how might this affect interest rates?

7. 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.

ANSWER: As a strong U.S. dollar dampens U.S. inflation, it can reduce the demand for loanable funds, and therefore reduce interest rates. 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.

8. Nominal versus Real Interest Rate. What is the difference between the nominal interest rate and real interest rate? What is the logic behind the Fisher effect’s implied positive relationship between expected inflation and nominal interest rates?

9. Real Interest Rate. Estimate the real interest rate over the last year. If financial market participants overestimate inflation in a particular period, will real interest rates be relatively high or low? Explain.

11. Impact of Stock Market Crises. During periods when investors suddenly become fearful that stocks are overvalued, they dump their stocks, and the stock market experiences a major decline. During these periods, interest rates also tend to decline. Use the loanable funds