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Nominal and Real Interest Rates

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. Nominal and Real Interest Rates.

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Nominal and Real Interest Rates

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  1. 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

  4. 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?

  6. Money Market Investment Demand MS1 MS2 r i i1 r1 i2 r2 MD ID Qm1 Qm2 Q Qi1 Qi2 Q

  7. LRAS PL SRAS1 PL2 PL1 AD2 AD1 Yfe Y2 Real GDP

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

  9. 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

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