Download Nominal and Real Interest Rates

Nominal and Real Interest Rates


Interest can be thought of as “rent
on money“
The fee (interest) is compensation to
the lender for foregoing other useful
investments that could have been
made with the loaned money
Nominal and Real Interest Rates



Nominal interest is the rate you will see
when you apply for a credit card or car
loan
It represents the lenders real profit
desired, plus inflation
The real interest rate expresses the cost
of borrowed funds after the expected
erosion of the value of those funds due to
the rise in the general price level
Example:





Assume that a lender wants to earn 5%
off of a loan and the inflation rate is 5%
How much more can the lender buy in real
terms once he is paid back?
Answer: zero
If the lender wanted the ability to buy 5%
more, he would need to charge 10%
The real interest rate expresses the cost
of borrowed funds after the expected
erosion of the value of those funds due to
the rise in the general price level
The Fisher Equation



r=i-∏
Where “r” is the real interest rate, “i”
is the nominal interest rate, and “∏”
is the inflation rate
Lenders must set the nominal
interest rate based on what they
expect the inflation rate to be
The effect of monetary policy on
interest rates


An expansion in the money supply,
generally results in a short term
decrease in real/nominal interest
rates, but an increase in nominal
interest rates in the long run.
Why?
Money Market
i
MS1
Investment Demand
MS2
r
i1
r1
i2
MD
Qm1
Qm2
Q
r2
ID
Qi1
Qi2
Q
PL
LRAS
SRAS1
PL2
PL1
AD2
AD1
Yfe
Y2
Real GDP
PL
LRAS
SRAS2
SRAS1
PL3
PL2
PL1
AD2
AD1
Yfe
Y2
Real GDP
Long-run interest rates


In the long-run the real interest rate
will go back to its full-employment
level
Due to the increased price level,
lenders expect higher inflation and
they will adjust the nominal interest
rate to reflect this expectation
Phillips curve
Inflation Rate




Phillips Curve
Unemployment Rate
The inverse
relationship
between inflation
and unemployment
Applies to the
short-run only
The Phillips curve is
vertical in the longrun. Why?
Changes in the
economy usually
result in
movements along
the Phillips curve