Nominal and Real Interest RatesNominal and Real Interest Rates

Interest can be thought of as “rent Interest can be thought of as “rent on money“on money“

The fee (interest) is compensation to The fee (interest) is compensation to the lender for foregoing other useful the lender for foregoing other useful investments that could have been investments that could have been made with the loaned money made with the loaned money

Nominal and Real Interest RatesNominal and Real Interest Rates

Nominal interestNominal interest is the rate you will see is the rate you will see when you apply for a credit card or car when you apply for a credit card or car loanloan

It represents the lenders real profit It represents the lenders real profit desired, plus inflationdesired, plus inflation

The The real interestreal interest rate expresses the cost of rate expresses the cost of borrowed funds after the expected erosion borrowed funds after the expected erosion of the value of those funds due to the rise of the value of those funds due to the rise in the general price level in the general price level

Example:Example: Assume that a lender wants to earn 5% off Assume that a lender wants to earn 5% off

of a loan and the inflation rate is 5%of a loan and the inflation rate is 5% How much more can the lender buy in real How much more can the lender buy in real

terms once he is paid back?terms once he is paid back? Answer: zeroAnswer: zero If the lender wanted the ability to buy 5% If the lender wanted the ability to buy 5%

more, he would need to charge 10%more, he would need to charge 10% The The real interestreal interest rate expresses the cost of rate expresses the cost of

borrowed funds after the expected erosion borrowed funds after the expected erosion of the value of those funds due to the rise of the value of those funds due to the rise in the general price level in the general price level

The Fisher EquationThe Fisher Equation

r = i - ∏r = i - ∏ Where “r” is the real interest rate, “i” Where “r” is the real interest rate, “i”

is the nominal interest rate, and “∏” is the nominal interest rate, and “∏” is the inflation rateis the inflation rate

Lenders must set the nominal Lenders must set the nominal interest rate based on what they interest rate based on what they expect the inflation rate to beexpect the inflation rate to be

The effect of monetary policy on The effect of monetary policy on interest ratesinterest rates

An expansion in the money supply, An expansion in the money supply, generally results in a short term generally results in a short term decrease in real/nominal interest decrease in real/nominal interest rates, but an increase in nominal rates, but an increase in nominal interest rates in the long run.interest rates in the long run.

Why?Why?

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Money Market Investment Demand

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Real GDP

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Real GDP

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Long-run interest ratesLong-run interest rates

In the long-run the real interest rate In the long-run the real interest rate will go back to its full-employment will go back to its full-employment levellevel

Due to the increased price level, Due to the increased price level, lenders expect higher inflation and lenders expect higher inflation and they will adjust the nominal interest they will adjust the nominal interest rate to reflect this expectationrate to reflect this expectation

Phillips curvePhillips curve The inverse The inverse

relationship relationship between inflation between inflation and unemploymentand unemployment

Applies to the Applies to the short-run onlyshort-run only

The Phillips curve is The Phillips curve is vertical in the long-vertical in the long-run. Why?run. Why?

Changes in the Changes in the economy usually economy usually result in result in movements along movements along the Phillips curvethe Phillips curve

Unemployment Rate

Phillips Curve

Infl

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Rate