Assuming that you want to calculate the equilibrium interest rate in a closed economy with a fixed exchange rate the formula is:
r = r* + (π – πe)/(1 – β(1 – θ))
where:
r = the equilibrium interest rate
r* = the world (or “neutral”) real interest rate
π = the inflation rate
πe = the expected inflation rate
β = the slope of the yield curve
θ = the percentage of financial assets that are held abroad
Now let’s break down each of these terms.
The world real interest rate r* is the interest rate that would prevail in the absence of inflation. In other words it is the “neutral” or “natural” interest rate. It is often referred to as the equilibrium real interest rate.
The inflation rate π is the percentage change in the price level from one period to the next. The expected inflation rate πe is the inflation rate that people expect to occur in the future.
The slope of the yield curve β is the difference between the interest rates on long-term and short-term government bonds. A positive β indicates that long-term interest rates are higher than short-term rates while a negative β indicates the reverse.
The percentage of financial assets that are held abroad θ is a measure of the degree of international capital mobility. A higher θ indicates that capital is more mobile and that interest rates in different countries are more closely linked.
So putting all of this together the equilibrium interest rate in a closed economy with a fixed exchange rate is:
r = r* + (π – πe)/(1 – β(1 – θ))
This formula tells us that the equilibrium interest rate is equal to the world real interest rate plus a term that captures the effects of inflation and the yield curve.
What is the equilibrium interest rate?
The equilibrium interest rate is the rate at which savers supply funds to borrowers and is determined by the demand for and supply of loanable funds.
How is the equilibrium interest rate calculated?
The equilibrium interest rate is calculated by adding the marginal cost of funds to the expected inflation rate.
What factors affect the equilibrium interest rate?
The equilibrium interest rate is affected by the demand for and supply of loanable funds as well as the marginal cost of funds and the expected inflation rate.
Why is the equilibrium interest rate important?
The equilibrium interest rate is important because it represents the rate at which savers are willing to supply funds to borrowers.
What happens if the equilibrium interest rate is not achieved?
If the equilibrium interest rate is not achieved it can lead to a shortage or surplus of loanable funds which can in turn lead to economic problems.
What is the marginal cost of funds?
The marginal cost of funds is the interest rate that banks must pay on their most expensive source of funds.
What is the expected inflation rate?
The expected inflation rate is the average expected inflation over the life of a loan.
How do changes in the demand for loanable funds affect the equilibrium interest rate?
Changes in the demand for loanable funds will lead to a corresponding change in the equilibrium interest rate.
An increase in the demand for loanable funds will lead to a higher equilibrium interest rate while a decrease in the demand for loanable funds will lead to a lower equilibrium interest rate.
How do changes in the supply of loanable funds affect the equilibrium interest rate?
Changes in the supply of loanable funds will lead to a corresponding change in the equilibrium interest rate.
An increase in the supply of loanable funds will lead to a lower equilibrium interest rate while a decrease in the supply of loanable funds will lead to a higher equilibrium interest rate.
How do changes in the marginal cost of funds affect the equilibrium interest rate?
Changes in the marginal cost of funds will lead to a corresponding change in the equilibrium interest rate.
An increase in the marginal cost of funds will lead to a higher equilibrium interest rate while a decrease in the marginal cost of funds will lead to a lower equilibrium interest rate.
How do changes in the expected inflation rate affect the equilibrium interest rate?
Changes in the expected inflation rate will lead to a corresponding change in the equilibrium interest rate.
An increase in the expected inflation rate will lead to a higher equilibrium interest rate while a decrease in the expected inflation rate will lead to a lower equilibrium interest rate.
What are the consequences of a higher equilibrium interest rate?
A higher equilibrium interest rate will lead to higher interest rates on loans which can in turn lead to decreased investment and consumption.
What are the consequences of a lower equilibrium interest rate?
A lower equilibrium interest rate will lead to lower interest rates on loans which can in turn lead to increased investment and consumption.
What is the relationship between the equilibrium interest rate and the demand for loanable funds?
The equilibrium interest rate is determined by the demand for and supply of loanable funds.
What is the relationship between the equilibrium interest rate and the supply of loanable funds?
The equilibrium interest rate is determined by the demand for and supply of loanable funds.
