Macroeconomics Study Guides

Keep the following two comprehensive study guides handy throughout your macroeconomics course study. They provide brief oulines for many of the major macroeconomics topics studied in this course and can help prepare you for your final economics exams.

Principles of Macroeconomics Lecture Notes

PART III: Interest Rate

Interest Rates

i_{0,1} = the nominal interest rate between periods 0 and 1

(the nominal return on the asset)

\pi^{e}_{0,1} = the expected inflation rate between periods 0 and 1

r^{e}_{0,1} = the expected real interest rate between periods 0 and 1


r^e _{0,1} = i_{0,1} - \pi^e _{0,1} (or \: i_{0,1} = \pi^e _{0,1} + r^e _{0,1)}

r^a _{0,1} = i_{0,1} - \pi^a _{0,1} (or \: i_{0,1} = \pi^a _{0,1} + r^a _{0,1)}

where r^{a} and \pi^{a} 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  r^{e} = (1 + i) / (1 + \pi ^e) - 1
  • Central Banks are very interested in r since it may affect the savings decisions of households and definitely affects the investment decisions of firms. The press talks about Central Banks setting i, but the Central Banks are really trying to set r.
  • 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 0.12 ( i = r^{e} + \pi^{e} ) 

Summary: i = 0.12

                        r^{e}= 0.05

                        \pi{e} = 0.07

  • Suppose that actual inflation is 0.10  (\pi^{a} > \pi^{e} ) 

In this case, r^{a} = 0.02 (r^{a} = i - \pi^{a})

Borrowers/Firms are better off

Lenders/Workers worse off

  • Suppose that actual inflation is 0.03  (\pi^{a} < \pi{e} )

In this case,  r^{a} = 0.09 \: ( r^{a} = i - \pi^{a} )

Borrowers/Firms are worse off

Lenders/Workers better off

It has been shown that higher inflation rates are correlated with more variability. 

People/Firms Don't Like the Uncertainty