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Nominal and Real Interest RatesNominal and Real Interest Rates

Interest can be thought of as rentInterest can be thought of as rent

on moneyon money

The fee (interest) is compensation toThe fee (interest) is compensation tothe lender for foregoing other usefulthe lender for foregoing other useful

investments that could have beeninvestments that could have been

made with the loaned moneymade with the loaned money

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Example:Example:

Assume that a lender wants to earn 5%Assume that a lender wants to earn 5%off of a loan and the inflation rate is 5%off of a loan and the inflation rate is 5%

How much more can the lender buy in realHow much more can the lender buy in realterms 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% TheThe real interestreal interest rate expresses the cost ofrate expresses the cost of

borrowed funds after the expected erosionborrowed funds after the expected erosionof the value of those funds due to the riseof the value of those funds due to the risein the general price levelin the general price level

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The Fisher EquationThe Fisher Equation

r = i - r = i -

Where r is the real interest rate, iWhere 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 nominalLenders must set the nominal

interest rate based on what theyinterest rate based on what they

expect the inflation rate to beexpect the inflation rate to be

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The effect of monetary policy onThe 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 termgenerally results in a short term

decrease in real/nominal interestdecrease in real/nominal interest

rates, but an increase in nominalrates, but an increase in nominal

interest rates in the long run.interest rates in the long run.

Why?Why?

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iMS1

i1

Q

MDi2

MS2

Qm1 Qm2

r

r1

Q

IDr2

Qi1 Qi2

Money Market Investment Demand

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PL

Real GDP

SRAS1

Yfe

AD1

LRAS

Y2

PL1

PL2

AD2

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PL

Real GDP

SRAS1

Yfe

AD1

LRAS

Y2

PL1

PL2

AD2

SRAS2

PL3

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Long-run interest ratesLong-run interest rates

In the long-run the real interest rateIn the long-run the real interest rate

will go back to its full-employmentwill go back to its full-employment

levellevel

Due to the increased price level,Due to the increased price level,

lenders expect higher inflation andlenders expect higher inflation and

they will adjust the nominal interestthey will adjust the nominal interest

rate to reflect this expectationrate to reflect this expectation

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Phillips curvePhillips curve

The inverseThe inverserelationshiprelationshipbetween inflationbetween inflationand unemploymentand unemployment

Applies to theApplies to theshort-run onlyshort-run only

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

Changes in theChanges in theeconomy usuallyeconomy usuallyresult inresult inmovements alongmovements alongthe Phillips curvethe Phillips curve

Unemployment Rate

Phillips Curve

Inflati o

n

Ra

te