Nominal and Real Interest Rates Interest can be thought of as “rent on money“ 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 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 Nominal interest is the rate you will see when you apply for a credit card or car loan 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 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 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

Example: Assume that a lender wants to earn 5% off of a loan and the inflation rate is 5% 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? How much more can the lender buy in real terms once he is paid back? Answer: zero Answer: zero If the lender wanted the ability to buy 5% more, he would need to charge 10% 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 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

The Fisher Equation r = i - ∏ r = i - ∏ Where “r” is the real interest rate, “i” is the nominal interest rate, and “∏” is the inflation rate 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 Lenders must set the nominal interest rate based on what they expect the inflation rate to be

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. 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? Why?

i MS 1 i1i1 Q MD i2i2 MS 2 Q m1 Q m2 r r1r1 Q ID r2r2 Q i1 Q i2 Money Market Investment Demand

PL Real GDP SRAS 1 Y fe AD 1 LRAS Y2Y2 PL 1 PL 2 AD 2

PL Real GDP SRAS 1 Y fe AD 1 LRAS Y2Y2 PL 1 PL 2 AD 2 SRAS 2 PL 3

Long-run interest rates In the long-run the real interest rate will go back to its full-employment level 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 Due to the increased price level, lenders expect higher inflation and they will adjust the nominal interest rate to reflect this expectation

Phillips curve The inverse relationship between inflation and unemployment The inverse relationship between inflation and unemployment Applies to the short-run only Applies to the short-run only The Phillips curve is vertical in the long- run. Why? The Phillips curve is vertical in the long- run. Why? Changes in the economy usually result in movements along the Phillips curve Changes in the economy usually result in movements along the Phillips curve Unemployment Rate Phillips Curve Inflation Rate