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Interest Rates & Inflation Real vs. Nominal Interest Rates Interest Rates • Reflects the cost of borrowing money (or benefit of saving it!) – There are short term & long term interest rates • Low interest rates are critical for a healthy economy (GDP) – As interest rates ↑ => cost of borrowing money ↑ => Investment (I) ↓ Short Term Interest Rates • The Federal Reserve only “controls” short term interest rates – Used by banks & currently = 0.0% • Federal Funds Rate changes over time to regulate GDP & inflation Long Term Interest Rates • Long term interest rates are determined by inflation expectations – Currently = 2.50% (10-year government bond) • As Expected Inflation ↑ => long term interest rates ↑ • Bond prices move inverse to interest rates. – bond prices ↓ => interest rate ↑ Investments & Inflation • Inflation directly affects your real return on any investment • If a bond pays 2.5% interest, what is your real return? “It Depends” on the rate of inflation! Adjusting Interest Rates for Inflation Nominal Interest Rate = Real Interest Rate + Expected Inflation Reworking above formula: Real = Nominal – Expected Inflation 10-year Gov’t Bond Purchase Nominal Interest Rate Nominal dollars per year: In 10-years: $1,000,000 2.50% $25,000 (interest per year) $1,000,000 principal paid back If expected inflation = 2.0%: • The real interest rate is 0.5% (2.5% - 2%) • Purchasing Power ↑ $5,000 per year Practice Test #3