Department

EconomicsCourse Code

ECO102H1Professor

Jack CarrLecture

40This

**preview**shows half of the first page. to view the full**2 pages of the document.**March 25th 2010

Inflation

Interest Rates and Inflation

Borrowers and lenders: concern is with Real interest rate Ã™ change in purchasing power

Nominal interest rate = Real Interest Rate + Expected inflation

Ã™

Real Interest Rate = Nominal Interest Rate Â± Expected Inflation

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1. Firm wishes to borrow for one year to build plant. Interest Rate is 10%.

2. Is this interest rate High or Low?

Answer: Depends on inflation rate.

Example:

Inflation 10% Ã†

(i) cost of building plant (materials, labour) will be 10% higher next

year

(ii) goods to be produced @ plant will sell @ 10% higher prices next

year

Ã– interest rate is low

Year

1981

2006

(nominal) interest rate,

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16%

4.25%

Expected inflation

13%

2.00%

Real interest Rate

3%

2.25%

Does inflation hurt savers?

Answer: only if unanticipated

Redistributive Effects (again)

Real Interest Rate 4%

Expected Inflation Rate 5%

Nominal Interest Rate 9%

#1 Actual Inflation (8%) > Expected Inflation (5%)

Real Interest Rate = 9% - 8% = 1% (not 4%)

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