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CHAPTER 14 © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard Expectations: The Basic Tools Prepared by: Fernando Quijano and Yvonn Quijano

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard2 of 32 Nominal Versus Real Interest Rates Interest Rates expressed in terms of dollars (or, more generally, in units of the national currency) are called nominal interest rates Interest rates expressed in terms of a basket of goods are called real interest rates. 14-1

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard3 of 32 Nominal Versus Real Interest Rates Definition and Derivation of the Real Interest Rate i t = nominal interest rate for year t. r t = real interest rate for year t. (1+ i t ): Lending one dollar this year yields (1+ i t ) dollars next year. Alternatively, borrowing one dollar this year implies paying back (1+ i t ) dollars next year. P t = price this year. P e t+1 = expected price next year. Figure

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard4 of 32 Nominal Versus Real Interest Rates then, the expected rate of inflation equals Consequently, Given, and knowing that If the nominal interest rate and the expected rate of inflation are not too large, a simpler expression is: The real interest rate is (approximately) equal to the nominal interest rate minus the expected rate of inflation.

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard5 of 32 Nominal Versus Real Interest Rates Here are some of the implications of the relation above: If if

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard6 of 32 Nominal and Real Interest Rates in the United States Since 1978 Nominal and Real One-Year T-bill Rates in the United States since 1978 Although the nominal interest rate has declined considerably since the early 1980s, the real interest rate was actually higher in 2001 than in Figure

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard7 of 32 Expected Present Discounted Values Computing Present Discounted Values The expected present discounted value of a sequence of future payments is the value today of this expected sequence of payments Figure

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard8 of 32 Computing Expected Present Discounted Values (a) One dollar this year is worth 1+i t dollars next year. (b) If you lend/borrow 1/(1+it) dollars this year, you will receive/repay dollar next year. (c) (c) One dollar is worth dollars two years from now. (d) The present discounted value of a dollar two years from today is equal to

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard9 of 32 Computing Expected Present Discounted Values The word discounted comes from the fact that the value next year is discounted, with (1+i t ) being the discount factor. (The 1-year nominal interest rate, i t, is sometimes called the discount rate.

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard10 of 32 A General Formula The present discounted value of a sequence of payments, or value in todays dollars equals: When future payments or interest rates are uncertain, then: Present discounted value, or present value are another way of saying expected present discounted value.

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard11 of 32 Using Present Values: Examples This formula has these implications: Present value depends positively on todays actual payment and expected future payments. Present value depends negatively on current and expected future interest rates.

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard12 of 32 Constant Interest Rates To focus on the effects of the sequence of payments on the present value, assume that interest rates are expected to be constant over time, then:

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard13 of 32 Constant Interest Rates and Payments When the sequence of payments is equalcalled them $z, the present value formula simplifies to: The terms in the expression in brackets represent a geometric series. Computing the sum of the series, we get:

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard14 of 32 Constant Interest Rates and Payments, Forever Assuming that payments start next year and go on forever, then: Using the property of geometric sums, the present value formula above is: Which simplifies to:

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard15 of 32 Zero Interest Rates If i = 0, then 1/(1+i) equals one, and so does (1/(1+i) n ) for any power n. For that reason, the present discounted value of a sequence of expected payments is just the sum of those expected payments.

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard16 of 32 Nominal Versus Real Interest Rates, and Present Values Replacing nominal interest with real interest rates to obtain the present value of a sequence of real payments, we get: Which can be simplified to:

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard17 of 32 Nominal and Real Interest Rates, and the IS-LM Model When deciding how much investment to undertake, firms care about real interest rates. Then, the IS relation must read: The interest rate directly affected by monetary policythe one that enters the LM relationis the nominal interest rate, then: The real interest rate is: 14-3

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard18 of 32 Nominal and Real Interest Rates, and the IS-LM Model Note an immediate implication of these three relations: The interest rate directly affected by monetary policy is the nominal interest rate. The interest rate that affects spending and output is the real interest rate. So, the effects of monetary policy on output depend on how movements in the nominal interest rate translate into movements in the real interest rate.

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard19 of 32 Money Growth, Inflation, Nominal and Real Interest Rates This section focuses on the following assertions: Higher money growth leads to lower nominal interest rates in the short run, but to higher nominal interest rates in the medium run. Higher money growth leads to lower real interest rates in the short run, but has no effect on real interest rates in the medium run. 14-4

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard20 of 32 Revisiting the IS-LM Model Reducing the IS relation, LM relation and relation between the real and nominal interest rate gives us: IS LM The IS curve is still downward sloping. The LM curve is upward sloping. The equilibrium is at the intersection of the IS curve and the LM curve.

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard21 of 32 Revisiting the IS-LM Model Equilibrium Output and Interest Rates The equilibrium level of output and the equilibrium nominal interest rate are given by the intersection of the IS curve and the LM curve. The real interest rate equals the nominal interest rate minus expected inflation. Figure

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard22 of 32 Nominal and Real Interest Rates in the Short Run The Short-run Effects of an Increase in Money Growth An increase in money growth increases the real money stock in the short run. This increase in real money leads to an increase in output and a decrease in both the nominal and the real interest rate. Figure

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard23 of 32 In the medium run, the real interest rate equals the natural interest rate, r n, then: Finally, in the medium run, inflation is equal to money growth: Nominal and Real Interest Rates in the Medium Run In the medium run,, then: The relation between the nominal interest rate and the real interest rate is: In the medium run, expected inflation is equal to actual inflation, so:

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard24 of 32 Nominal and Real Interest Rates in the Medium Run In the medium run, the nominal interest rate increases one for one with inflation. This result is known as the Fisher effect, or the Fisher Hypothesis. For example, an increase in nominal money growth of 10% is eventually reflected by a 10% increase in the rate of inflation, a 10% increase in the nominal interest rate, and no change in the real interest rate.

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard25 of 32 From the Short Run to the Medium Run In the short run, lower nominal interest rates lead to higher output and inflation. In the medium run, this situation changes. In the short run, Over time, In the medium run,

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard26 of 32 From the Short Run to the Medium Run In words: So long as the real interest rate is below the natural real interest rate, output is higher than the natural level of output, and unemployment is below its natural rate. From the Phillips curve relation, we know that as long as unemployment is below the natural rate of unemployment, inflation increases. As inflation increases, it becomes higher than nominal money growth, leading to negative real money growth. In the medium run, the real interest rate increases back to it initial value.

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard27 of 32 From the Short Run to the Medium Run The Adjustment of the Real and the Nominal Interest Rate to an Increase in Money Growth An increase in money growth leads initially to a decrease in both the real and the nominal interest rate. Over time, the real interest rate returns to its initial value. The nominal interest rate converges to a new higher value, equal to the initial value plus the increase in money growth. Figure

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard28 of 32 Evidence on the Fisher Hypothesis To see if increases in inflation lead to one-for- one increases in nominal interest rates, economists look at: Nominal interest rates and inflation across countries. The evidence of the early 1990s finds substantial support for the Fisher hypothesis. Swings in inflation, which should eventually be reflected in similar swings in the nominal interest rate. Again, the data appears to fit the hypothesis quite well.

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard29 of 32 Evidence on the Fisher Hypothesis The 3-Month Treasury Bill Rate and Inflation since 1927 The increase in inflation from the early 1960s to the early 1980s was associated with an increase in the nominal interest rate. The decrease in inflation since the mid-1980s has been associated with a decrease in the nominal interest rate. Figure

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard30 of 32 Evidence on the Fisher Hypothesis Figure 14-7 has at least three interesting features: The steady increase in inflation from the early 1960s to the early 1980s was associated with a roughly parallel increase in the nominal interest rate. The nominal interest rate lagged behind the increase in inflation in the 1970s, while the disinflation of the early 1980s was associated with an initial increase in the nominal interest rate. The other episode of inflation underscores the importance of the medium-run qualifier in the Fisher hypothesis.

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard31 of 32 Nominal Interest Rates and Inflation Across Latin America in the Early 1990s Figure 1 Nominal Interest Rates and Inflation: Latin America,

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Chapter 14:Expectations: The Basic Tools © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard32 of 32 Key Terms nominal interest rate real interest rate expected present value discount factor discount rate present discounted value present value Fisher effect, Fisher hypothesis

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