Macroeconomics Study Guides
Principles of Macroeconomics Lecture Notes
PART III: Interest Rate
Interest Rates
= the nominal interest rate between periods 0 and 1
(the nominal return on the asset)
= the expected inflation rate between periods 0 and 1
= the expected real interest rate between periods 0 and 1
Definitions
where and are the actual real interest rate and inflation
Interest Rate Notes
- The Formula given is approximate. The approximation is less accurate the higher the levels of inflation and nominal interest rates. The exact formula is
- Central Banks are very interested in since it may affect the savings decisions of households and definitely affects the investment decisions of firms. The press talks about Central Banks setting , but the Central Banks are really trying to set .
- 3 easy ways of measuring expected inflation:
- Recent actual inflation.
- Survey of forecasters.
- Interest rate spread on nominal vs. inflation-indexed securities (WSJ)
Why We Care About Inflation?
- Note: We will have a whole lecture on this later in the course
- Inflation is Unpredictable
- Indexing Costs (even if you know the inflation rate - you have to deal with it).
- Menu Costs (have to go and re-price everything)
- Shoe-Leather Costs (you want to hold less cash - have to go to the bank more often).
- Caveat: There may be some benefits to small inflation rates - more on this later.
- An Example of how inflation can affect real returns.
- Suppose we agree that a real rate of 0.05 over the next year is fair.
- borrowing rate, salary growth rate, etc.
- Suppose we also agree that expected inflation over the next year is 0.07.
- We should then set the nominal return equal to
Borrowers/Firms are better off
Lenders/Workers worse off
People/Firms Don't Like the Uncertainty