When expected inflation increases, the real cost of borrowing ________, and bond supply ________:

Question

BlackTom AI · Accepted Answer

Real interest rate = nominal interest rate − expected inflation (r = i − π^e). Therefore, an increase in expected inflation (π^e ↑) reduces the ex ante real cost of borrowing, holding the nominal rate i fixed.

1) Relevant knowledge points and concepts
- Fisher equation: i ≈ r + π^e, so r = i − π^e.
- Borrowers issue (supply) bonds; lenders demand them. Lower real borrowing costs make borrowing (issuing bonds) more attractive, so bond supply rises.
- In the short run, nominal rates may not fully adjust immediately to higher inflation expectations, so the immediate effect is a lower real rate.

2) Step-by-step reasoning
- Start with r = i − π^e.
- Increase π^e by Δπ^e > 0 while i is initially unchanged → r falls by the same amount.
- A lower real interest cost means firms and governments pay less in real terms to borrow, increasing their willingness to issue bonds.
- Thus the supply curve of bonds shifts right (bond supply increases). Simultaneously, expected inflation reduces the real return to bondholders, lowering bond demand (not asked but consistent).

3) Intermediate calculation example
- Example: i = 5%, initial π^e = 2% → r = 3%.
- If π^e rises to 4% and i stays 5% → r = 1% (real cost decreased by 2 percentage points).
- Lower real cost → greater issuance of bonds → bond supply increases.

4) Why the correct answer is correct
- Because r falls when expected inflation rises, borrowing becomes cheaper in real terms, encouraging more bond issuance; therefore real cost decreases and bond supply increases.

5) Why other options are incorrect
- b (increases; increases): wrong because r does not increase when π^e rises.
- c (increases; decreases): wrong for the same reason and the supply direction is reversed.
- d (decreases; decreases): wrong because while r decreases, bond supply does not decrease—issuance becomes more attractive so supply increases.

Conclusion: The correct choice is a. decreases; increases.

When expected inflation increases, the real cost of borrowing , and bond supply :Single choice

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When expected inflation increases, the real cost of borrowing ________, and bond supply ________:Single choice