Question

An economy is making a rapid recovery after experiencing a decade long recession. Briefly explain the impacts that this development can have on funding needs of businesses and the real interest rate of the economy.

Answer 1

Since the economy is recovering from recession, it is fair to assume that the firm will experience an increase in demand for their products. This increase in demand for goods and services implies that the firms will need to scale up their production. This will thus be matched by an increase in investment demand as firms will need to pay for worker's wages and other costs such as holding up inventory. Thus, the demand for funds will increase in the period after recession. As a result, the nominal interest rate that is charged by the banks will also increase as more firms will need the funds. The change in the real interest rate depends on the inflation in the economy. If increase in inflation is less than increase in nominal interest rate, then real interest rate of the economy will increase, and vice-versa.