Final answer:
A higher nominal rate coupled with high inflation can result in a lower real interest rate, reducing the purchasing power of money repaid. Deflation can increase the real interest rate, potentially reducing loan issuance and leading to recession. Interest rates decline with a rise in credit supply if demand does not increase.
Step-by-step explanation:
The relationship between a higher nominal rate and a lower real interest rate can be understood through the concept of inflation. When inflation is taken into account, the real interest rate is the nominal interest rate minus the rate of inflation. Therefore, if the nominal rate is high but inflation is higher, the real interest rate can actually be lower, meaning the purchasing power of the money being repaid is less than when the loan was taken out.
If the nominal interest rate is high due to increased demand for money and credit, leading interest rates higher, this can decrease purchasing power because borrowers are paying back funds that have less value due to inflation. On the other hand, deflation can cause the real interest rate to be higher than the nominal rate, which could potentially decrease the number of loans being made as banks suffer losses and become less willing to issue new loans, leading to decreased aggregate demand and potential recession.
In the context of the financial market, if there is a rise in demand for credit, usually interest rates remain the same or increase to reflect the higher demand. Conversely, when there is a rise in supply of credit without a corresponding increase in demand, this tends to lead to a decline in interest rates, as lenders must offer more attractive rates to entice borrowers.