1. March 27, 2014 Notes: Real versus Nominal Interest Rates HW: Activity 4-9

2. Real versus Nominal Interest Rates Intro Q: You bought a 1 year bond for $1,000 and the bond paid an interest rate of 10%, at the end of the year would you be 10% wealthier? What if the inflation rate was 8% You would only be 2% wealthier! What if the inflation rate was 12%? You would be able to buy 2% less!

3. NOMINAL INTEREST RATE: Interest rate before taking inflation into account (the rate quoted in loan and deposit agreements) But to avoid purchasing power erosion through inflation… REAL INTEREST RATE: interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender. Expresses the change in your purchasing power! The Real Interest Rate is the increase in purchasing power the lender wants to receive to forgo consumption now for consumption in the future. The expected real interest rate represents the amount you need to receive in real terms to forgo consumption now for consumption in the future.

4. Real versus Nominal Inflation Rates The Fisher Equation shows relationship between the Nominal Interest Rate, the Real Interest Rate, and the Inflation Rate: r = i – Obviously banks and customers do not know what inflation is going to be, so expected real interest rate is: re = i - e A bank sets the nominal interest rate equal to its expected real interest rate + expected inflation rate: i = re + e

5. Real versus Nominal Interest Rates If the Fed increases MS, PL increases… If the Fed decreases MS, PL decreases… In the SR, increases in MS decrease Nominal Interest Rate and Real Interest Rate (and vice versa) In the LR, an increase in the MS will increase the PL and the Nominal Interest Rate.