March 25th 2010
Interest Rates and Inflation
Borrowers and lenders: concern is with Real interest rate Ù change in purchasing power
Nominal interest rate = Real Interest Rate + Expected inflation
Real Interest Rate = Nominal Interest Rate ± Expected Inflation
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.
Inflation 10% Æ
(i) cost of building plant (materials, labour) will be 10% higher next
(ii) goods to be produced @ plant will sell @ 10% higher prices next
Ö interest rate is low
(nominal) interest rate,
Real interest Rate
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%)