Final answer:
The real interest rate is inversely related to the supply of loanable funds because an increase in loanable funds leads to lenders reducing the interest rates to attract borrowers, decreasing the cost of borrowing.
Step-by-step explanation:
The real interest rate is inversely related to the supply of loanable funds because an increase in loanable funds supply leads to reduced interest rates. When there is more money available to be loaned, lenders compete by offering lower interest rates to attract borrowers. This competition drives the price of borrowing down. Conversely, when the supply of loanable funds is low, lenders can charge higher interest rates as borrowers compete for the limited funds.
An example of how interest rates can fluctuate is the scenario where the nominal interest rate is 7%, and the rate of inflation is 3%, resulting in a real interest rate of 4%. In the event of deflation, such as a 2% decrease in prices, the real interest rate would increase to 9%, which can complicate financial markets. Lenders may become less willing to lend as the real interest rate affects their return on investment, while borrowers face higher costs of borrowing. This dynamic can influence the economic activity and potentially lead to a recession if the demand in the economy falls significantly due to high real interest rates and reduced lending.