Firms require capital to invest in productive opportunities. The best firms with the most profitable opportunities can attract capital away from inefficient firms with less profitable opportunities. Investors supply firms with capital at a cost called the interest rate. The interest rate that investors require is determined by several factors, including the availability of production opportunities, the time preference for current consumption, risk, and inflation.

Suppose the Federal Reserve (the Fed) decides to tighten credit by contracting the money supply. Use the following graph by moving the black X to show what happens to the equilibrium level of borrowing and the new equilibrium interest rate.

Equilibrium081680INTEREST RATE, r (Percent)CAPITAL (Billions of dollars)S1S2D

Which tend to be more volatile, short- or long-term interest rates?

Short-term interest rates

Long-term interest rates

If the inflation rate was 2.60% and the nominal interest rate was 6.60% over the last year, what was the real rate of interest over the last year? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average. Round intermediate calculations to four decimal places.

4.00%

5.00%

4.60%

3.40%