Players have a private rate of return on a $100 investment, but only half of each group has $100. Equilibrium loan repayment amount is determined the intersection of lenders’ minimum acceptable and borrowers’ maximum acceptable repayment amounts.
Key Learning Objectives:
- Equilibrium Interest Rate: Supply and demand determine the equilibrium interest rate. Absent investment-return uncertainty, those with the lowest opportunity cost lend to those with the highest real return on investment.
- Fisher Effect: The nominal interest rate (approximately) equals the real interest rate plus the inflation rate. Thus, a change in certain inflation has a predictable effect on nominal interest rates, and no effect on real interest rates.
- Effects of Inflation Uncertainty: With nominal repayment amount fixed, higher than expected inflation reduces the real value of the loan repayment, harming lenders and benefiting borrowers. With lower than expected inflation, the higher than anticipated real value of the repayment harms borrowers and benefits lenders. In addition, inflation uncertainty reduces the volume of loans if agents are risk averse.
- Main Courses: macroeconomics; finance
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