Suppose the interest rate which banks in Techland charge each other for overnight loans is 5%, the long-run nominal interest rate is 4.5%, and the long-run expected inflation rate is 3%
i) What is the long-run expected real interest rate?
ii) How will the long-run expected real interest rate be affected if the central bank of Techland starts purchasing government bonds from banks?
i) The long-run expected real interest rate can be obtained by subtracting the long-run expected inflation rate from the long-run nominal interest rate. Therefore, long-run expected real interest rate in this case is 4.5% - 3% = 1.5%.
ii) If the central bank of Techland starts purchasing government bonds from private banks, the supply of reserves will increase. This will lead to a fall in the cost of borrowing funds for private banks. As a result, they will be able to make more loans. This will lead to a decrease in the long-run nominal interest rate. If the long-run expected inflation rate remains unchanged, the long-run expected real interest rate will fall.
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