Nominal and Real Interest Rates

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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

2
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

3
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

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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

5
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?

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LRAS
PL
SRAS2
SRAS1
PL3
PL2
PL1
AD2
AD1
Yfe
Y2
Real GDP
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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

10
Phillips curve

• The inverse relationship between inflation and
  unemployment
• Applies to the short-run only
• The Phillips curve is vertical in the long-run.
  Why?
• Changes in the economy usually result in
  movements along the Phillips curve

Inflation Rate
Phillips Curve
Unemployment Rate