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Interest Rates & Inflation What are real interest rates?

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Presentation on theme: "Interest Rates & Inflation What are real interest rates?"— Presentation transcript:

1 Interest Rates & Inflation What are real interest rates?

2 Unit Test #2 Block Period 50 Multiple Choice Questions No Free Response or Study Guide 2 on-line practice tests Test Review sheet (see website) Review formula sheet Topics: GDP, Unemployment, CPI, GDP Deflator, Inflation & Interest Rates

3 Interest Rates & Inflation Real vs. Nominal Interest Rates

4 Interest Rates Reflects the cost of borrowing money (or benefit of saving it!) –There are short term & long term interest rates The Federal Reserve controls short term interest rates –Used by banks & currently = 0.0% Long term interest rates are determined by inflation expectations –Currently = 2.50% (10-year government bond) –As Expected Inflation ↑ => long term interest rates ↑ –Bond prices move inverse to interest rates. bond prices ↓ => interest rate ↑ Low interest rates are critical for a healthy economy (GDP) –As interest rates ↑ => cost of borrowing money ↑ => Investment (I) ↓

5 Investments & Inflation Inflation directly affects your real return on any investment If a bond pays 2.5% interest, what is your real return? “It Depends” on the rate of inflation!

6 Nominal Interest Rate = Real Interest Rate + Expected Inflation Reworking above formula: Real = Nominal – Expected Inflation If expected inflation = 2.0%: The real interest rate is 0.5% (2.5% - 2%) Purchasing Power ↑ $5,000 per year 10-year Gov’t Bond Purchase $1,000,000 Nominal Interest Rate 2.50% Nominal dollars per year: $25,000 (interest per year) In 10-years:$1,000,000 principal paid back Adjusting Interest Rates for Inflation

7 Practice Test #3


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