1. Expectations: The Basic Tools Chapter 14

2. © 2013 Pearson Education, Inc. All rights reserved.14-2 14-1 Nominal versus Real Interest Rates Figure 14-1 Definition and Derivation of the Real Interest Rate

3. © 2013 Pearson Education, Inc. All rights reserved.14-3 14-1 Nominal versus Real Interest Rates

4. © 2013 Pearson Education, Inc. All rights reserved.14-4 14-1 Nominal versus Real Interest Rates

5. © 2013 Pearson Education, Inc. All rights reserved.14-5 14-1 Nominal versus Real Interest Rates Figure 14-2 Nominal and Real One-Year T-Bill Rates in the United States since 1978

6. © 2013 Pearson Education, Inc. All rights reserved.14-6 Focus: Why Deflation Can Be Very Bad: Deflation and the Real Interest Rate During the Great Depression Table 1 The Nominal Interest Rate, Inflation, and the Real Interest Rate, 1929–1933

7. © 2013 Pearson Education, Inc. All rights reserved.14-7 14-2 Nominal and Real Interest Rates, and the IS–LM Model

8. © 2013 Pearson Education, Inc. All rights reserved.14-8 14-3 Money Growth, Inflation, Nominal and Real Interest Rates Figure 14-3 Equilibrium Output and Interest Rates

9. © 2013 Pearson Education, Inc. All rights reserved.14-9 14-3 Money Growth, Inflation, Nominal and Real Interest Rates Figure 14-4 The Short-Run Effects of an Increase in Money Growth

10. © 2013 Pearson Education, Inc. All rights reserved.14-10 10 of 32 14-3 Money Growth, Inflation, and Nominal and Real Interest Rates Nominal and Real Interest Rates in the Medium Run  In the medium run, the rate of inflation is equal to the rate of money growth minus the rate of growth of output.  In the medium run, output returns to the natural level of output, At the ``natural’’ level of unemployment, So that, in the medium-run,

11. © 2013 Pearson Education, Inc. All rights reserved.14-11 11 of 32 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. 14-3 Money Growth, Inflation, and Nominal and Real Interest Rates Nominal and Real Interest Rates in the Medium Run

12. © 2013 Pearson Education, Inc. All rights reserved.14-12 12 of 32 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, 14-3 Money Growth, Inflation, and Nominal and Real Interest Rates From the Short Run to the Medium Run

13. © 2013 Pearson Education, Inc. All rights reserved.14-13 13 of 32 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. 14-3 Money Growth, Inflation, and Nominal and Real Interest Rates From the Short Run to the Medium Run

14. © 2013 Pearson Education, Inc. All rights reserved.14-14 14-3 Money Growth, Inflation, Nominal and Real Interest Rates Figure 14-5 The Adjustment of the Real and the Nominal Interest Rates to an Increase in Money Growth

15. © 2013 Pearson Education, Inc. All rights reserved.14-15 Focus: Nominal Interest Rates and Inflation across Latin America in the Early 1990s Figure 1 Nominal Interest Rates and Inflation: Latin America, 1992– 1993

16. © 2013 Pearson Education, Inc. All rights reserved.14-16 14-3 Money Growth, Inflation, Nominal and Real Interest Rates Figure 14-6 The Treasury Bill Rate and Inflation in the United States since 1927

17. © 2013 Pearson Education, Inc. All rights reserved.14-17 14-4 Expected Present Discounted Values Figure 14-7 Computing Present Discounted Values

18. © 2013 Pearson Education, Inc. All rights reserved.14-18 14-4 Expected Present Discounted Values

19. © 2013 Pearson Education, Inc. All rights reserved.14-19 Appendix: Deriving the Expected Present Discounted Value Using Real or Nominal Interest Rates

20. © 2013 Pearson Education, Inc. All rights reserved.14-20 Appendix: Deriving the Expected Present Discounted Value Using Real or Nominal Interest Rates