Chapter 27, Problem 1CQ

To determine

The factors that influence the rate of interest in Country U.

Explanation of Solution

Option (a):

When the population that saves more increases, it leads to increase the aggregate saving in an economy. This will increase the availability of money in the economy. This in turn reduces the interest rate.

Option (b):

When the government increases the borrowing in order to finance the budget deficit, the rate of interest will increase. This is because the fiscal expansion leads to a decrease in the availability of money for the private investment, which is termed as crowding out. As a result, the demand for loanable fund increases, which causes an increase in the rate of interest.

Option (c):

The real interest rate is the rate that is adjusted to eliminate the effects of inflation. The real interest rate can be calculated by deducting inflation rate from the money rate of interest.

$\text{Nominal interest rate}=\text{Real interet rate}+\text{Inflation rate}$

The above equation states that there is a positive relationship between nominal interest rate and inflation, whereas a negative relationship between real interest rate and inflation. Thus, an increase in the inflation rate leads to an increase in the nominal interest rate.

Option (d):

When there is a war, it leads to inflationary situation. The increase in inflation leads to a reduction in the money value, which in turn increases the nominal interest rate.

Option (e):

When the investment opportunities in Continent E increases, the rate of interest will decrease. This is because the investment opportunities leads to a higher demand for money. As a result, the rate of interest increases.

Economics Concept Introduction

Crowding out: Crowding out effect refers to the decrease in the availability of money for private investment due to increase in the fiscal expansion.