If the Central Bank lowers the nominal interest rate how this would create a self-reinforcing dynamic between the money market and the product market?

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pnrjulius eNotes educator| Certified Educator

There are a lot of complex dynamic relationships between the monetary economy and the real economy, but since this question focused on interest rates I think that's a good place to start.

Lowering the nominal interest rate will, ceteris paribus, lower the real interest rate. This will increase the money supply, because people will be more willing to take out loans if the real interest rate is lower, and loans are the primary mechanism for the expansion of the money supply.
An expanded money supply will, again ceteris paribus, raise prices; how much it raises them depends on how "sticky" prices are compared with production quantities---that is, how much easier or harder it is to change prices as opposed to changing the amount of goods produced. If prices are very "flexible", they will respond immediately and the monetary expansion will simply cause inflation and not affect real output. But if prices are "sticky", they will be harder to adjust than quantity produced, and real output will expand.

Assuming that prices do go up (in the real world, monetary expansion is usually accompanied by some combination of inflation and expanded output), this will put further downward pressure on the real interest rate, even if the nominal interest rate remains the same. For example, a nominal interest rate of 3% is a real interest rate of 1% if you have 2% inflation; but if you have 4% inflation then that same 3% nominal rate is a -1% real interest rate.

Thus, there is a self-reinforcing feedback loop: Lower interest rates in the money market cause inflation in the product market, which causes lower interest rates, which cause more inflation.

This higher inflation may also trigger higher expected inflation, which can be self-fulfilling---if people expect prices to rise, consumers will stock up on products and businesses raise their prices in anticipation, which can create the very inflation that people fear.

Fortunately, none of these feedback loops actually lead to an explosive outcome where they are completely out of control. We have quite good models now for how much inflation and change in output will come from a given interest rate change.

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