22.F. Real Vs. Nominal Interest Rates

22.f. Real vs. Nominal Interest Rates

One important type of economic variable is an interest rate. An interest rate is a rate of return promised by a borrower to a lender. Let’s say, for example, that you go to the bank to borrow $100. The bank has an 11% interest rate on one-year loans. This means, I you decide to borrower, you promise to pay the $11 interest plus the $100 that was borrowed. There are different interest rates in the economy, and it varies according to who is borrowing, the length it’s borrowed for and other factors. Most interest rates and other rates of return tend to move up and down together.

Nominal GDP shares a measurement problem with interest rates and other rates of return. The problem is an interest rate indicates how quickly the nominal value of an interest-bearing asset increases over time. It doesn’t reveal how quickly the change is in real terms. For example, you have a savings account with an interest rate of 5% a year and you have $500 in the beginning of your first year. At the end of your first year, you have $525 in your saving account. This is a good deal if you have zero inflation. Without inflation, the price level doesn’t change, and the $525 you have buys 5% more goods than your initial amount did. But let’s say that there is inflation. That means that what was once only $500 worth in the first year, now cost $525. Now your savings account is not worth anything today than it was in the beginning.

Economists usually use the concept of real interest rate to distinguish changes in the real value of assets from changes in nominal value. The real interest rate, also known as real rate of return, on an asset is the rate at which the real value or purchasing power of the asset increases over time. Refer to the conventional measurement of interest rates to distinguish them from real interest rates. The nominal interest rate, or nominal rate of return, is the rate at which the nominal value of an asset increases over time. The nominal interest rate is known by the symbol i.

Real interest rate = Nominal interest rate – Inflation rate (22.3) = i-п

The above equation shows that real interest rate is related to the nominal interest rate and the inflation rate.

Let’s consider again the savings account paying 5% interest. If there is a zero inflation rate, the real interest rate on your saving account is the 5% nominal interest rate minus the 0% inflation rate. The 5% real interest rate means that you can purchase 5% more goods at the end of the year than in the beginning. But if there is inflation, real inflation is 5% t you are left with 0%. Your purchasing power is not greater at then end.

Expected real interest rate. For any nominal interest rate, real interest rate depends on the rate of inflation over the period of the loan or deposit, lets say, a year. But inflation can’t be determined until the year is over. When a loan or deposit is made, the real interest rate that is received is uncertain. Because the actual real interest rate is unknown, borrowers and lenders must make a decision on how much to borrow or lend. They do this on the basis of real interest rate. The figure out the real interest rate in advance, so real interest rate they expect depends on what the inflation is thought to be. The expected real interest rate is given as

Expected real interest rate = nominal interest rate-expected rate of inflation (22.4) r = i-пe

If people are correct with their expectations, the expected real inflation rate and real interest rate received will be the same. Economists use various means to measure expected inflation. There are a few methods. One way is to take a survey and ask the public how much they expect the rate of inflation should be. Another way is to assume the publics expectations are the same as the government or private forecasts. Another possibility is that inflation expectation is an extrapolation from the recent history of inflation rates. Which ever method is used, there is no perfect way to measure. So this leaves room for errors.

Quiz Questions:

1. True or False: Rates of return and interest rates do not move up and down together. 2. Define Real interest rate 3. Define nominal interest rate 4. Borrowers and lenders determine the interest rate by a. Real interest rate b. Nominal interest rate c. Expected real interest rate

Answers:

1. False 2. Real interest rate is an asset is the rate at which the real value or purchasing power of the asset increases over time. 3. Nominal interest rate is the rate at which the nominal value of an asset increases over time 4. a. Real interest rate