<ol>
<li>Higher price level will not lead to people spend more. You can see from AD-AS diagram that aggregate demand is downward sloping curve (see the picture below). Hence, ceteris paribus at higher price levels people spend less. So already your first link in the chain is completely incorrect. Hence no need to examine the others - if your original premise is wrong the whole logical chain breaks down.</li>
</ol>

<p><a href="https://i.sstatic.net/YAdEU.png" rel="nofollow noreferrer"><img src="https://i.sstatic.net/YAdEU.png" alt="enter image description here"></a></p>

<ol start="2">
<li>The fisher equation <span class="math-container">$i= \pi+r$</span>, where <span class="math-container">$\pi$</span> is inflation <span class="math-container">$i$</span> nominal interest rate and <span class="math-container">$r$</span> real interest rate, can indeed be rearranged as <span class="math-container">$i-\pi=r$</span> but that does not mean the inflation necessarily leads to lower real interest - this is not some sort of relationship where <span class="math-container">$i$</span> and <span class="math-container">$\pi$</span> are exogenously exerting influence on <span class="math-container">$r$</span>. This is endogenous system, you can as well keep it in its original form <span class="math-container">$i=\pi+r$</span> and conclude that just <span class="math-container">$i$</span> increases to compensate for increasing inflation. In fact that’s most often the case because real interest rates are (at least in short run) the least flexible of the three variables in the fisher equation. But in general you can’t say higher inflation leads to higher real interest rate.</li>
</ol>

<p>PS: I personally did not downvoted this question so I can only make conjecture why others downvoted it, but I think it got downvoted because there is not much effort put into it. You could resolve this question by just googling AD-AS graph and the fisher equation. This question sounds like you are not willing to do even minimum effort in researching the topic yourself. I personally don’t downvote for that but I can understand why some people would.</p>

CC BY-SA 4.0
2020-03-05T09:21:50.190Z
"You could resolve this question by just googling AD-AS graph and the fisher equation" How could I google "fisher equation" if I have never heard about said equation in the first place?
KarmaPeasant
CC BY-SA 4.0
2020-03-05T09:25:55.863Z
Also, I learned about the interest rate effect in this Khan academy video (https://youtu.be/oLhohwfwf_U?t=468 ) I just reversed the effect described. Does it mean that the video is wrong?
KarmaPeasant
CC BY-SA 4.0
2020-03-05T09:27:27.100Z
@user161005 1. you obviously heard about it since you say in your question that we know nominal interest rate is equal to inflation and real interest rate. So the place where you learned this should definitely told you that this is the fisher equation and if not you can try to just put into google “nominal interest equals inflation plus real interest” and that’s literally the first search. 2. As I said I did not downvoted so please don’t focus on PS in comments here since it won’t change your point total - that’s my constructive advice so others won’t downvote your Q, take it or leave it
1muflon1
CC BY-SA 4.0
2020-03-05T09:34:07.793Z
But what about the video? Is the video wrong or I misunderstood this part?
KarmaPeasant
CC BY-SA 4.0
2020-03-05T09:35:34.817Z
@user161005 oh sorry you posted that the same time as I did my comment so I did not noticed it. Also can you please clarify what do you mean by it reversed the effect that I described? Which part of my description? I don’t think Sal says there something that would be inconsistent with what I said here.
1muflon1
CC BY-SA 4.0
2020-03-05T10:22:06.713Z
You misunderstood about "reversed" part. I meant that I just reversed effect described in the video. The video describes how lower price level leads to cheaper loans. I just reversed the logic. And by the way, by "people spend more, save less" I meant that marginal propensity to save has decreased.
KarmaPeasant
CC BY-SA 4.0
2020-03-05T10:36:20.657Z
"Higher price level will not lead to people spend more"  They will, but in nominal terms. Like suppose I was spending ¥100  and saving ¥100 out of earned ¥200. But then all prices suddenly doubled (except my wage). Now in order to preserve quality of my life I will need to spend all ¥200, saving zero ¥. In real terms my spending is the same, but nominally it increased. And I don't have savings anymore. So my savings can't be used for lending money.
KarmaPeasant
CC BY-SA 4.0
2020-03-05T10:55:28.130Z
@user161005 1. Inflation means all prices increase including factor prices such as wages, rent etc. not just goods prices. So that example is not correct representation of inflation, you would have to include some sort of frictions such as sticky wages to get something like that but that’s a special case and nowhere in your question nor in comments here you mentioned that. 2. But for real interest rate what matter is the real value of saving spending. If the aggregate prices increase then in real terms you have to spend less if you are rational so your savings in real terms should increase.
1muflon1
CC BY-SA 4.0
2020-03-05T11:08:21.623Z
Hence its not correct to assume people will “preserve their quality of life.” In case their wages will not change due to sticky wages for example they would spend even less in real terms because of negative income effect assuming aggregate bundle of goods people consume can be thought of as a normal good (which pretty much has to be true for most people in the economy)
1muflon1
CC BY-SA 4.0
2020-03-05T11:30:34.410Z
Do you agree with this (from textbook by Krugman):"An increase in the aggregate price level, other things equal, reduces the purchasing power of a given amount of money holdings. To purchase the same basket of goods and services as before, people and firms now need to hold more money. So, in response to an increase in the aggregate price level, the public tries to increase its
money holdings, either by borrowing more or by selling other assets such as bonds. This reduces the funds available for lending to other borrowers and has the effect of driving interest rates up"
KarmaPeasant
CC BY-SA 4.0
2020-03-05T11:43:25.377Z
@user161005 but that’s nominal interest rate not real interest rate you in your question said you talk about real interest rate. I agree higher inflation will usually ceteris paribus increase the nominal interest rate in fact that was part of my answer. Also note the krugman does not assume sticky wages in that answer hence there is no income effect there
1muflon1
CC BY-SA 4.0
2020-03-05T11:56:18.350Z
Also to further clarify why the sticky wages matter - if there are sticky wages the assumption people will buy the same basket of food is completely absurd. Of course if you make that extra assumption and ignore the fact that sticky wages would change consumption patterns you can get weird results... but they would not be correct
1muflon1
CC BY-SA 4.0
2020-03-05T12:21:31.597Z
Do you agree also with this line from Krugman: "An increase in the aggregate price level, other things equal, reduces the purchasing power of many assets." It's from part where he explains the wealth effect. For me it looks like here he assumes the short run because in the long run prices for all assets will adjust to the price level, thus there would be no decrease in purchasing power of assets due to higher price level if we talk about the long run
KarmaPeasant
CC BY-SA 4.0
2020-03-05T12:45:28.773Z
@user161005 it does, but you are mixing here multiple things together. Higher goods prices definitely reduce the aggregate demand - but if you talk about inflation which means not only higher increases in goods market, but also higher income for household there will be no-net wealth effect. If Krugman there talks about wealth effect you either took it out of context so there are other factors not mentioned in your quote (maybe he assumes sticky wages but from that first quote it seems not)or it’s not even about inflation but increase in aggregate goods prices and you mix effects on r and i
1muflon1
CC BY-SA 4.0
2020-03-05T13:07:19.827Z
1."but if you talk about inflation which means not only higher increases in goods market, but also higher income for household there will be no-net wealth effect." In other words, higher prices for labor and assets. It's why I suspected that Krugman assumes the short run here. BUT, why talk about short run and sticky wages when we explain why the AD (which is the same both for the short run and the long run) is downward slopping? I mean, in this case it misses explanation for the long run. 2."it’s not even about inflation but increase in aggregate goods prices" Wait, what is the difference?
KarmaPeasant
CC BY-SA 4.0
2020-03-05T14:31:35.267Z
1. To be honest I would have to read Krugman’s book because, and this is not your fault, it’s not possible to see context from the short exert posted in comment here. I would recommend you to read the full chapter to get the whole context. 2. Aggregate goods prices can increase independently of wages for example if wages are sticky, also if there are menu costs the reverse can be true wages can increase while goods prices staying constant. 3. The downward sloping supply is about relationships between what firms are willing to bring to the market and price not necessarily what customer demand
1muflon1
CC BY-SA 4.0
2020-03-05T14:38:49.860Z
" downward sloping supply" Wait, where?? The only thing that is downward slopping is the Aggregate Demand. Did you mean the AD?
KarmaPeasant
CC BY-SA 4.0
2020-03-05T14:43:50.763Z
@user161005 oh yes that was a mistake sorry, we recently talked about supply, and wires must got crossed there. The demand is downward sloping because at higher prices people can afford less goods and services but if the prices are higher just due to the inflation then also their incomes should increase - simply inflation outside sticky wages does not affect demand (or other imperfections like menu costs etc).
1muflon1
CC BY-SA 4.0
2020-03-05T14:50:36.187Z
By the way I think I know based on your comments now what Krugman was talking about. The AD is downward sloping because of the income effect but that effect assumes that only aggregate prices of final goods not wages increase (but that’s completely separate from any interest  rate or other considerations and due to you answer I thought you think the income effect is caused by inflation but it isn’t - it’s caused by the fact that only goods prices for example with sticky wages go ahead of all other prices. If there is genuine inflation that affects all prices it has no income effect
1muflon1
CC BY-SA 4.0
2020-03-06T06:24:23.197Z
"I agree higher inflation will usually ceteris paribus increase the nominal interest rate". But wouldn't it mean that when inflation happens real interest usually decreases? And wouldn't it imply that due to lower real interest rates it becomes cheaper for firms to take loans (in the short run)? Or would loans become more expensive for firms?
KarmaPeasant
CC BY-SA 4.0
2020-03-06T06:34:01.797Z
@user161005 no inflation usually does not have any direct influence on real interest rate. Remember when we call things in economics real - real GDP, real wages etc we denote things that are in the end not affected by inflation. There might be some special cases when real interest responds to inflation in short run but generally the real interest is determined by underlying time value of money and things like what’s the (real) return on investments in the economy.
1muflon1
CC BY-SA 4.0
2020-03-06T06:37:39.580Z
In fact that’s one of the reasons why central banks can control inflation quite well just by setting nominal interest rates - in fact most of the time central bank actually does not create new monetary base but just on purpose targets higher/lower nominal interest rate to get inflation. There are policy mixes that could in principle affect real interest rates that’s why Fed and ECB were pursuing both low nominal interest rates and huge money base expansion at the same time but general consensus is it did little to change actual real interest rate - that’s how not responsive it is
1muflon1
CC BY-SA 4.0
2020-03-06T10:53:44.050Z
1.Another question. Suppose inflation happened and we are currently in the short run. Given such circumstances, in what case firms will be more willing to take loans and spend them than before: if the nominal interest rate has decreased or if the real interest rate has decreased? 2.In the interest rate theory do we experience change in the nominal interest rate or the real interest rate? From what you said I suppose it must be the nominal interest rate, but I want to be sure.
KarmaPeasant
CC BY-SA 4.0
2020-03-07T01:50:04.997Z
2.Do you agree that inflation decreases the marginal propensity to save in the short run? 3.Do you agree that a decrease in the marginal propensity to save will lead to higher interest rate?
KarmaPeasant
CC BY-SA 4.0
2020-03-07T10:09:39.247Z
@user161005 yes the nominal interest matters. Inflation **in itself** does not affect the marginal propensity to save. Let me explain why. First inflation means that all prices are increasing if all prices double your wage doubles as well + inflation also affects the nominal interest rate so if the old i was 2% but now inflation is 5% higher then also new i will increase to 5%. But if you assume that there are some frictions like for example sticky wages then it can change the marginal propensity to save in short run but it can’t do it just by itself which is a whole world of difference
1muflon1
CC BY-SA 4.0
2020-03-07T10:15:50.920Z
But assuming that there is some source of friction inflation would mainly impact the nominal interest rate not the real interest rate. Again real interest rate is usually very inflexible determined mainly by time value of money or risk free rate of return you can earn on investments in the economy. However, nominal interest rate is the one that matters for borrowing decisions still because you want to be compensated for that inflation
1muflon1
CC BY-SA 4.0
2020-03-07T14:46:00.440Z
1.You can want to edit #1 point in your answer, I updated my post because it seems that I miscommunicated what I really meant - that the marginal propensity to save will decrease under inflation IN THE SHORT RUN 2. If the real interest rate is determined by time value of money, then why can't it be changed by inflation? In the short run inflation will change the time value of money (i.e. it will become even more lucrative to spend money now, rather than save them ).
KarmaPeasant
CC BY-SA 4.0
2020-03-05T09:12:53.020Z
2020-03-05T09:22:47.343Z
2020-03-05T09:22:47.343Z
1muflon1
<p>According to the interest rate theory higher price level will lead to following chain of events <strong>in the short run</strong>:
Marginal propensity to save will decrease(<strong>ratio</strong> of spending/saving will change, people will spend relatively more compared with saving) => savings will decrease => less money will become available for lending => the interest rate will increase => firms will spend less because loans became more expensive. Or in other words, higher price level => more expensive loans for firms.</p>

<p>BUT, we also know that the real interest rate equals the nominal interest rate minus the inflation rate. Higher inflation would decrease the real interest rate. Wouldn't lower real interest rate make borrowing money less expensive for firms?</p>

<p>P.S. Why is my question being downvoted? Please, provide feedback so I could improve it. I can't read minds.</p>

CC BY-SA 4.0
2020-03-05T05:42:31.730Z
I don't see how a decrease in savings can have any effect on lending at all. Fractional reserve requirements these days are typically 0%. Also, higher prices would mean people borrow more and therefore spend more.
Frank
CC BY-SA 4.0
2020-03-05T06:15:17.913Z
@Frank And I don't understand why you don't see connection and I don't understand how low fractional reserve requirement will help banks to preserve amount of money available for lending. Imagine extreme case scenario: Nominal prices skyrocketed and now all household have to spend everything they earn, with literally zero savings. Banks just wouldn't have money to lend, even if their fractional reserve requirement was strictly equal to zero.
KarmaPeasant
CC BY-SA 4.0
2020-03-05T06:19:13.783Z
@Frank "Also, higher prices would mean people borrow more" I don't see how it follows in all possible cases (like when the government is printing money).
KarmaPeasant
CC BY-SA 4.0
2020-03-05T06:32:55.423Z
@KennyLJ Probably because in the short run wages are sticky. We're are talking about the short run here.
KarmaPeasant
CC BY-SA 4.0
2020-03-05T06:39:35.470Z
@user161005 it seems you misunderstand how fractional reserve works. Issued loans are *new* money. The deposit part of a loan is spent at a different bank and becomes a capital asset and part of reserves for new loans. Therefore between multiple banks fractional reserve lending equals credit amplification. Besides, households today don't save; they borrow and spend.
Frank
CC BY-SA 4.0
2020-03-05T06:41:18.573Z
@Frank Are you saying that the interest rate theory that explains downward sloppiness of the AD curve is false?
KarmaPeasant
CC BY-SA 4.0
2020-03-05T06:42:39.100Z
In general this question is illustrative of how classic economics poorly reflects reality, how irrelevant it is, and why few economists predicted the credit crisis.
Frank
CC BY-SA 4.0
2020-03-05T06:45:11.363Z
@Frank What is your economics school?
KarmaPeasant
CC BY-SA 4.0
2020-03-05T06:51:13.413Z
@user161005 irrelevant. More important to this is supporting empirical evidence. But I suspect you will first need to understand the role of credit today before continuing to talk about money and interest rates.
Frank
CC BY-SA 4.0
2020-03-05T06:53:26.033Z
A good empirical falsifier is house prices. Clearly, in the run up to 2007, increasing house prices had no negative effect on interest rates or spending at all. On the contrary, more money (loans) were available.
Frank
CC BY-SA 4.0
2020-03-05T06:54:58.140Z
@Frank Can you recommend me some things to read that would educate me about "the role of credit today", money and interest rates?
KarmaPeasant
CC BY-SA 4.0
2020-03-05T06:58:36.817Z
I also agree with KennyLJ. I don't see that higher prices of basic goods has any effect on spending. Most people borrow to spend on homes and cars and spend mostly on loan repayments. Slightly higher prices would most likely result in increased in edge case loan defaults and not much else.
Frank
CC BY-SA 4.0
2020-03-05T07:00:07.703Z
Let us [continue this discussion in chat](https://chat.stackexchange.com/rooms/105180/discussion-between-frank-and-user161005).
Frank
<inflation><interest-rate><debt>
How to reconcile fact that "real interest=nominal interest - inflation" with prediction of the interest rate theory about expensivity of loans?
KarmaPeasant
# How to reconcile fact that "real interest=nominal interest - inflation" with prediction of the interest rate theory about expensivity of loans?

(Asked by: username_0 on 2020-03-05)

According to the interest rate theory higher price level will lead to following chain of events **in the short run**:
Marginal propensity to save will decrease(**ratio** of spending/saving will change, people will spend relatively more compared with saving) => savings will decrease => less money will become available for lending => the interest rate will increase => firms will spend less because loans became more expensive. Or in other words, higher price level => more expensive loans for firms.

BUT, we also know that the real interest rate equals the nominal interest rate minus the inflation rate. Higher inflation would decrease the real interest rate. Wouldn't lower real interest rate make borrowing money less expensive for firms?

P.S. Why is my question being downvoted? Please, provide feedback so I could improve it. I can't read minds.

**Tags:** inflation, interest-rate, debt
> **Comments:**
> **username_1**: I don't see how a decrease in savings can have any effect on lending at all. Fractional reserve requirements these days are typically 0%. Also, higher prices would mean people borrow more and therefore spend more.  
> **username_0**: @Frank And I don't understand why you don't see connection and I don't understand how low fractional reserve requirement will help banks to preserve amount of money available for lending. Imagine extreme case scenario: Nominal prices skyrocketed and now all household have to spend everything they earn, with literally zero savings. Banks just wouldn't have money to lend, even if their fractional reserve requirement was strictly equal to zero.  
> **username_0**: @Frank "Also, higher prices would mean people borrow more" I don't see how it follows in all possible cases (like when the government is printing money).  
> **username_0**: @KennyLJ Probably because in the short run wages are sticky. We're are talking about the short run here.  
> **username_1**: @user161005 it seems you misunderstand how fractional reserve works. Issued loans are *new* money. The deposit part of a loan is spent at a different bank and becomes a capital asset and part of reserves for new loans. Therefore between multiple banks fractional reserve lending equals credit amplification. Besides, households today don't save; they borrow and spend.  
> **username_0**: @Frank Are you saying that the interest rate theory that explains downward sloppiness of the AD curve is false?  
> **username_1**: In general this question is illustrative of how classic economics poorly reflects reality, how irrelevant it is, and why few economists predicted the credit crisis.  
> **username_0**: @Frank What is your economics school?  
> **username_1**: @user161005 irrelevant. More important to this is supporting empirical evidence. But I suspect you will first need to understand the role of credit today before continuing to talk about money and interest rates.  
> **username_1**: A good empirical falsifier is house prices. Clearly, in the run up to 2007, increasing house prices had no negative effect on interest rates or spending at all. On the contrary, more money (loans) were available.  
> **username_0**: @Frank Can you recommend me some things to read that would educate me about "the role of credit today", money and interest rates?  
> **username_1**: I also agree with KennyLJ. I don't see that higher prices of basic goods has any effect on spending. Most people borrow to spend on homes and cars and spend mostly on loan repayments. Slightly higher prices would most likely result in increased in edge case loan defaults and not much else.  
> **username_1**: Let us [continue this discussion in chat](https://chat.stackexchange.com/rooms/105180/discussion-between-frank-and-user161005).  

---

## 1 answers

### Answer by username_2 on 2020-03-05. Score: 0

1. Higher price level will not lead to people spend more. You can see from AD-AS diagram that aggregate demand is downward sloping curve (see the picture below). Hence, ceteris paribus at higher price levels people spend less. So already your first link in the chain is completely incorrect. Hence no need to examine the others - if your original premise is wrong the whole logical chain breaks down.

[![enter image description here](https://i.sstatic.net/YAdEU.png)](https://i.sstatic.net/YAdEU.png)

2. The fisher equation $i= \pi+r$, where $\pi$ is inflation $i$ nominal interest rate and $r$ real interest rate, can indeed be rearranged as $i-\pi=r$ but that does not mean the inflation necessarily leads to lower real interest - this is not some sort of relationship where $i$ and $\pi$ are exogenously exerting influence on $r$. This is endogenous system, you can as well keep it in its original form $i=\pi+r$ and conclude that just $i$ increases to compensate for increasing inflation. In fact that’s most often the case because real interest rates are (at least in short run) the least flexible of the three variables in the fisher equation. But in general you can’t say higher inflation leads to higher real interest rate.

PS: I personally did not downvoted this question so I can only make conjecture why others downvoted it, but I think it got downvoted because there is not much effort put into it. You could resolve this question by just googling AD-AS graph and the fisher equation. This question sounds like you are not willing to do even minimum effort in researching the topic yourself. I personally don’t downvote for that but I can understand why some people would.

> **Comments:**
> **username_0**: "You could resolve this question by just googling AD-AS graph and the fisher equation" How could I google "fisher equation" if I have never heard about said equation in the first place?  
> **username_0**: Also, I learned about the interest rate effect in this Khan academy video (https://youtu.be/oLhohwfwf_U?t=468 ) I just reversed the effect described. Does it mean that the video is wrong?  
> **username_2**: @user161005 1. you obviously heard about it since you say in your question that we know nominal interest rate is equal to inflation and real interest rate. So the place where you learned this should definitely told you that this is the fisher equation and if not you can try to just put into google “nominal interest equals inflation plus real interest” and that’s literally the first search. 2. As I said I did not downvoted so please don’t focus on PS in comments here since it won’t change your point total - that’s my constructive advice so others won’t downvote your Q, take it or leave it  
> **username_0**: But what about the video? Is the video wrong or I misunderstood this part?  
> **username_2**: @user161005 oh sorry you posted that the same time as I did my comment so I did not noticed it. Also can you please clarify what do you mean by it reversed the effect that I described? Which part of my description? I don’t think Sal says there something that would be inconsistent with what I said here.  
> **username_0**: You misunderstood about "reversed" part. I meant that I just reversed effect described in the video. The video describes how lower price level leads to cheaper loans. I just reversed the logic. And by the way, by "people spend more, save less" I meant that marginal propensity to save has decreased.  
> **username_0**: "Higher price level will not lead to people spend more"  They will, but in nominal terms. Like suppose I was spending ¥100  and saving ¥100 out of earned ¥200. But then all prices suddenly doubled (except my wage). Now in order to preserve quality of my life I will need to spend all ¥200, saving zero ¥. In real terms my spending is the same, but nominally it increased. And I don't have savings anymore. So my savings can't be used for lending money.  
> **username_2**: @user161005 1. Inflation means all prices increase including factor prices such as wages, rent etc. not just goods prices. So that example is not correct representation of inflation, you would have to include some sort of frictions such as sticky wages to get something like that but that’s a special case and nowhere in your question nor in comments here you mentioned that. 2. But for real interest rate what matter is the real value of saving spending. If the aggregate prices increase then in real terms you have to spend less if you are rational so your savings in real terms should increase.  
> **username_2**: Hence its not correct to assume people will “preserve their quality of life.” In case their wages will not change due to sticky wages for example they would spend even less in real terms because of negative income effect assuming aggregate bundle of goods people consume can be thought of as a normal good (which pretty much has to be true for most people in the economy)  
> **username_0**: Do you agree with this (from textbook by Krugman):"An increase in the aggregate price level, other things equal, reduces the purchasing power of a given amount of money holdings. To purchase the same basket of goods and services as before, people and firms now need to hold more money. So, in response to an increase in the aggregate price level, the public tries to increase its money holdings, either by borrowing more or by selling other assets such as bonds. This reduces the funds available for lending to other borrowers and has the effect of driving interest rates up"  
> **username_2**: @user161005 but that’s nominal interest rate not real interest rate you in your question said you talk about real interest rate. I agree higher inflation will usually ceteris paribus increase the nominal interest rate in fact that was part of my answer. Also note the krugman does not assume sticky wages in that answer hence there is no income effect there  
> **username_2**: Also to further clarify why the sticky wages matter - if there are sticky wages the assumption people will buy the same basket of food is completely absurd. Of course if you make that extra assumption and ignore the fact that sticky wages would change consumption patterns you can get weird results... but they would not be correct  
> **username_0**: Do you agree also with this line from Krugman: "An increase in the aggregate price level, other things equal, reduces the purchasing power of many assets." It's from part where he explains the wealth effect. For me it looks like here he assumes the short run because in the long run prices for all assets will adjust to the price level, thus there would be no decrease in purchasing power of assets due to higher price level if we talk about the long run  
> **username_2**: @user161005 it does, but you are mixing here multiple things together. Higher goods prices definitely reduce the aggregate demand - but if you talk about inflation which means not only higher increases in goods market, but also higher income for household there will be no-net wealth effect. If Krugman there talks about wealth effect you either took it out of context so there are other factors not mentioned in your quote (maybe he assumes sticky wages but from that first quote it seems not)or it’s not even about inflation but increase in aggregate goods prices and you mix effects on r and i  
> **username_0**: 1."but if you talk about inflation which means not only higher increases in goods market, but also higher income for household there will be no-net wealth effect." In other words, higher prices for labor and assets. It's why I suspected that Krugman assumes the short run here. BUT, why talk about short run and sticky wages when we explain why the AD (which is the same both for the short run and the long run) is downward slopping? I mean, in this case it misses explanation for the long run. 2."it’s not even about inflation but increase in aggregate goods prices" Wait, what is the difference?  
> **username_2**: 1. To be honest I would have to read Krugman’s book because, and this is not your fault, it’s not possible to see context from the short exert posted in comment here. I would recommend you to read the full chapter to get the whole context. 2. Aggregate goods prices can increase independently of wages for example if wages are sticky, also if there are menu costs the reverse can be true wages can increase while goods prices staying constant. 3. The downward sloping supply is about relationships between what firms are willing to bring to the market and price not necessarily what customer demand  
> **username_0**: " downward sloping supply" Wait, where?? The only thing that is downward slopping is the Aggregate Demand. Did you mean the AD?  
> **username_2**: @user161005 oh yes that was a mistake sorry, we recently talked about supply, and wires must got crossed there. The demand is downward sloping because at higher prices people can afford less goods and services but if the prices are higher just due to the inflation then also their incomes should increase - simply inflation outside sticky wages does not affect demand (or other imperfections like menu costs etc).  
> **username_2**: By the way I think I know based on your comments now what Krugman was talking about. The AD is downward sloping because of the income effect but that effect assumes that only aggregate prices of final goods not wages increase (but that’s completely separate from any interest  rate or other considerations and due to you answer I thought you think the income effect is caused by inflation but it isn’t - it’s caused by the fact that only goods prices for example with sticky wages go ahead of all other prices. If there is genuine inflation that affects all prices it has no income effect  
> **username_0**: "I agree higher inflation will usually ceteris paribus increase the nominal interest rate". But wouldn't it mean that when inflation happens real interest usually decreases? And wouldn't it imply that due to lower real interest rates it becomes cheaper for firms to take loans (in the short run)? Or would loans become more expensive for firms?  
> **username_2**: @user161005 no inflation usually does not have any direct influence on real interest rate. Remember when we call things in economics real - real GDP, real wages etc we denote things that are in the end not affected by inflation. There might be some special cases when real interest responds to inflation in short run but generally the real interest is determined by underlying time value of money and things like what’s the (real) return on investments in the economy.  
> **username_2**: In fact that’s one of the reasons why central banks can control inflation quite well just by setting nominal interest rates - in fact most of the time central bank actually does not create new monetary base but just on purpose targets higher/lower nominal interest rate to get inflation. There are policy mixes that could in principle affect real interest rates that’s why Fed and ECB were pursuing both low nominal interest rates and huge money base expansion at the same time but general consensus is it did little to change actual real interest rate - that’s how not responsive it is  
> **username_0**: 1.Another question. Suppose inflation happened and we are currently in the short run. Given such circumstances, in what case firms will be more willing to take loans and spend them than before: if the nominal interest rate has decreased or if the real interest rate has decreased? 2.In the interest rate theory do we experience change in the nominal interest rate or the real interest rate? From what you said I suppose it must be the nominal interest rate, but I want to be sure.  
> **username_0**: 2.Do you agree that inflation decreases the marginal propensity to save in the short run? 3.Do you agree that a decrease in the marginal propensity to save will lead to higher interest rate?  
> **username_2**: @user161005 yes the nominal interest matters. Inflation **in itself** does not affect the marginal propensity to save. Let me explain why. First inflation means that all prices are increasing if all prices double your wage doubles as well + inflation also affects the nominal interest rate so if the old i was 2% but now inflation is 5% higher then also new i will increase to 5%. But if you assume that there are some frictions like for example sticky wages then it can change the marginal propensity to save in short run but it can’t do it just by itself which is a whole world of difference  
> **username_2**: But assuming that there is some source of friction inflation would mainly impact the nominal interest rate not the real interest rate. Again real interest rate is usually very inflexible determined mainly by time value of money or risk free rate of return you can earn on investments in the economy. However, nominal interest rate is the one that matters for borrowing decisions still because you want to be compensated for that inflation  
> **username_0**: 1.You can want to edit #1 point in your answer, I updated my post because it seems that I miscommunicated what I really meant - that the marginal propensity to save will decrease under inflation IN THE SHORT RUN 2. If the real interest rate is determined by time value of money, then why can't it be changed by inflation? In the short run inflation will change the time value of money (i.e. it will become even more lucrative to spend money now, rather than save them ).  

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