Interest Rates & Monetary Policy Part I

AP Macroeconomics

Where did we come from?

In a previous lesson, we related monetary policy to changes in the monetary variables such as the federal funds rate, the money supply, and velocity.

http://www.stlouisfed.org/inplainenglish/monetary_policy.htm

Where are we going?

In this lesson, we will explore the relationship between nominal interest rate and the real interest rate.

We will also discuss the Fisher Effect, which demonstrates how changes in the money supply affect nominal interest in the long run.

http://www.extirpated.org/3.html

Nominal and Real Interest Rates… The nominal interest rate

is the rate that appears on the financial pages of newspapers and ads of financial institutions.

The real interest rate is the increase in purchasing power the lender wants to receive to forego consumption now and in the future.

http://www.etoro.com/blog/forex-news/31082012/the-importance-of-real-nominal-and-effective-interest-rates/

The relationship between the two…

There are two relationships:

Ex ante real interest rate, which is expected interest rate and equals the nominal interest rate – the expected rate of inflation.

Ex poste real interest rate, which is the real interest rate actually received and equals the nominal interest rate minus the actual rate of inflation.

http://lifewithlauren.com/2011/10/16/post-college-relationships-and-how-to-let-them-change-as-you-do/

Technically, the ex ante interest rate will equal the ex poste

interest rate if people accurately anticipate the inflation rate.

The Fisher Effect

(no, not the Fish Effect)

This relationship (that is, that between the real interest rate and the nominal interest rate) is called:

http://www.petsfoto.com/top-10-beautiful-colorful-fish/

The Fisher Effect Unveiled…

When we look at the equation of exchange, we see that changes in the money supply lead to changes in the price level.

These changes in the price level change the nominal interest rate once they are anticipated (nominal interest rate includes inflation).

Changes in MS Changes in the Price Level…which in turn lead to Changes in the Nominal Interest Rate!

And now…

Some resources:

Monetary policy and the Fed:

http://www.stlouisfed.org/inplainenglish/monetary_policy.htm

Reffonomics:http://www.reffonomics.com/

Morton workbook: Activity 41; Module 29, pp. 277-283

Works Cited

Economics of Seinfeld. http://yadayadayadaecon.com/

Krugman, Paul, and Robin Wells. Krugman’s Economics for AP. New York: Worth Publishers.

Morton, John S. and Rae Jean B. Goodman. Advanced Placement Economics: Teacher Resource Manual. 3rd ed. New York: National Council on Economic Education, 2003. Print.

Reffonomics. www.reffonomics.com.