1. MARK YOUR CALENDARS!! TUESDAY APRIL, 28 TH ECON FIELDTRIP!! ($9) Chicago Board Options Exchange (CBOE) Meet some traders Tour the trading floor and watch the animals – LIVE Visit the Federal Reserve Bank of Chicago Return to PR by 2:30 Required: MUST Bring School ID’s No Shorts or Blue Jeans

2. How Can Inflation Help and Hurt? Real Interest Rates vs. Nominal Interest Rates Real Wages vs. Nominal Wages Borrowing vs. Lending “Golden Rule” Nominal = Real + Inflation Real = Nominal - Inflation

3. If your NOMINAL wages = + 5% Your REAL wages = -5% Rule: Inflation is not a problem IF your wages keep up! Let’s assume inflation = 10% REAL WAGES VS. NOMINAL WAGES

4. What about businesses?? Inflation causes an increase in the cost of all factors of production.. Sellers must keep raising the prices of products. If they can’t pass on price increases to their customers they lose profitablility.

5. How are you effected by Inflation?? Savings/Investments – Your investments must keep up with the rate of inflation or you are losing money each year. – You need a “real” rate of return greater than zero. Real = nominal - inflation

6. If you were to invest $1000 for 1 year, what is the lowest rate of interest you would need to receive to keep from losing money? This year’s expected rate of INFLATION If inflation = 10% You must receive $1100 one year from today, or you will lose money on this investment. Interest Rates vs. Inflation

7. BANKS are in business to LEND MONEY BANKS MUST EARN A POSITIVE “REAL” RATE OF RETURN Banks must charge nominal interest rates that are at least equal to inflation. So, interest rates track inflation rates!! If inflation increases, interest rates increase!!

8. RATE OF INFLATION VS. INTEREST RATES Interest rates Inflation rate

9. Figure 3 Real and Nominal Interest Rates

10. How do Real and Nominal Interest Rates Effect You? Let’s say you put your money in the bank and earn a nominal interest rate of 2% per year. If Inflation was 4% over this time period, what is your REAL rate of return on this investment? Real interest rate = Nominal interest rate – Inflation REAL = 2% -4% = -2% Not a good investment IF inflation = 1%, then real interest = 2% -1% = 1% Savers need to beat inflation!!

11. So how can you GAIN from inflation? WHAT if you borrowed $1,000 for one year. The bank charges a Nominal interest rate of 5%. (the rate you pay) During the year inflation was 10%. Real interest rate = Nominal interest rate – Inflation = 5% - 10% = -5% Is the real interest rate what you pay? No, but if you earned at least the inflation rate then your net cost was -5%.

12. So, what does all this mean for you? WAGES You must earn wage increases at least as much as inflation to keep your REAL wages from declining. SAVING/INVESTING Investors/Savers must earn a positive real rate of interest Nominal rate > inflation BORROWING Lenders must earn a real rate of interest greater than zero, Borrowers can benefit from inflation by borrowing at FIXED rates, below the rate of inflation

13. Who is helped and who is hurt by high inflation? 1.Banks extend many fixed rate loans. H-G-U 1.Hurt, since they are only receiving money back at a fixed interest 2.A farmer buys machinery with a fixed rate loan to be repaid over 10 years 1.2. Gain, since he earns more money and pays a fixed rate 3.Your family buys a new home with an adjustable rate mortgage, the rate you pay adjusts with interest rates. 1.Hurt, since you will pay higher interest if inflation causes rates to rise 4.Your savings are in a savings account paying a fixed rate of interest 1.Hurt, since your receive only a fixed rate and interest rates and prices of everything are rising.

14. 1.A widow lives entirely on a fixed income from a pension the woman receives from her former employer. 1.Hurt, since prices are going up and the interest she receives is fixed. 2.A retired couple lives entirely on income from a pension the woman receives from her former employer. 1.Unclear, since we don’t know if the pension is INDEXED to inflation. 3.A retired man lives entirely on income from Social Security. Unclear, since although SS is indexed to inflation we don’t know if it will keep up with the man’s personal expenses. 4. The federal gov. has a $ 5 Billion debt. 1.Unclear, since we don’t know if it’s borrowed at fixed rates or adjustable.

15. Another scenario You buy a house right now for 200k If you pay a fixed rate of interest (say 4% per year for 30 years). The amount you pay is fixed, it doesn’t change over time! Your home should appreciate in value by at least the rate of inflation, because all prices are going up, real estate as well! If your salary increases along with inflation and that is greater than 4%, over time the cost of paying off your loan will get lower and lower. BUT your income must increase by more than 4% (Cost of living increases, raises, etc.)

16. Congratulations!! You just bought a house! Now, how are you going to pay for it? House cost: $250,000 10% down payment = $25,000 $225,000 loan The bank will lend you money in two different ways: Option A Borrow @ 4.4 % FIXED RATE for 30 years Option B Borrow @ 3.4% ADJUSTABLE one time per year – NO Cap Which would you choose??

17. It depends on your expectations about inflation and your tolerance for risk! If inflation is higher than 4.4% (say, 10%) Real Interest rate = 4.4 % - 10% = -5.6% How would you gain? Your home might increase in value at 10%, while you only pay 4.4% What if inflation stayed below 4.4 %? (1.4%) Real Interest rate = 4.4% - 1.4% = 3.4% You would earn closer to 1.4% on your home value, while paying 4.4% to own it!