Download Day Two - Southwestern

Deflation and the real rate of interest
I borrow $100 at a nominal rate of interest of 5 percent.
How much must I repay? _______
What is the purchasing power of the $______ I repay, compared to the purchasing power of the
$100 I borrowed?
Answer:
Nominal
interest
rate
If inflation is 0%, then I am paying back ______ purchasing
power than I borrowed.
If inflation is 5%, then I am paying back ______ purchasing
power that I borrowed.
If inflation is 3%, then I am paying back ______ purchasing
power than I borrowed.
If inflation is -8%, then I am paying back ______ purchasing
power than I borrowed.
Inflation
rate
5%
0%
5%
5%
5%
3%
5%
-8%
Real
interest
rate
An increase in prices _______________ burden to the borrower.
A decrease in prices _______________ burden to the borrower.
See pp. 481-2 for to see the contribution of deflation to the Great Depression.
John Maynard Keynes published The General Theory of Employment, Interest, and Money in
1936.
“Keynesian” economics is “demand-side” economics, where aggregate demand is considered
central to the performance of the national economy. In this theory there is a tradeoff: We can
have higher growth and lower unemployment OR lower inflation.
High AD -> high output and low unemployment; high (demand-pull) inflation
Low AD -> low output and high unemployment; low (demand-pull) inflation
What if the inflation is not caused by high AD?
Cost-push inflation occurs when increase in production costs prompt a “wage-price spiral.” For
example,
Increase in energy prices->
increase in production costs->
increase in prices to buyers->
increase in wages and salaries-> ?
Principle tools to raise or lower AD?