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ECON 310 Lecture Notes - Lecture 5: Nominal Interest Rate, Real Interest Rate, Economic Equilibrium

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School
U of M
Department
Economics
Course
ECON 310
Professor
Maciej Dudek

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ECON 310 verified notes
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ECON 310 Lecture 4: ECON310 Lecture 4 The.equation of exchange & Debt instruments(to be continued)

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ECON 310 Lecture Notes - Lecture 5: Nominal Interest Rate, Real Interest Rate, Economic Equilibrium

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ECON 310 Lecture Notes - Lecture 6: Nominal Interest Rate, Loanable Funds, Real Interest Rate

Document Summary

Rate of return=1% p= , 5% and . A bond"s price and yield to maturity are linked by the equation showing its coupon payments, face value (fv) and maturity in n years (1) p= c/(1+i) + c/(1+i)^2 . c/(1+i)^n + fv/(1+i)^n. Coupon and fv do not change, if we know the price in the bond market, we can determine the equilibrium interest. The bond market approach is useful when considering how the factors of demand and supply for bonds affect the interest rate. Price is the only factor to consider when drawing the demand and supply curves for bonds. If the price of bonds changes, we move along the demand curve, changing quantity demanded. Equilibrium price of bonds and quantity of bonds increase as a result of the rightward shift (2) a decrease in wealth will shift the demand curve d1 inward to d2.

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Related Questions

An upward-sloping term structure of interest rates indicates:

A.Ā the real rate of return is lower for short-term bonds than for long-term bonds.

B.Ā there is an indirect relationship between real interest rates and time to maturity.

C.Ā there is an indirect relationship between nominal interest rates and time to maturity.

D.Ā the nominal rate is declining as the real rate rises as the time to maturity increases.

E.Ā the nominal rate is increasing even though the real rate is constant as the time to maturity increases.

1. Nominal and real interest rates:Ā 

a. Explain the difference between real and nominal interest rates.Ā 

b. Which of these two interest rates is relevant for investment and consumption decisions and why?Ā 

c. How is the real interest rate calculated ex-post? How is the real interest rate calculated ex-ante?Ā 

Ā 

2. Fisher parity

a. Write down the approximation formula of the Fisher parity.

b. What is the real interest rate if the nominal interest rate is 6% and the expected inflation rate is 1%?

c. How is the real interest rate affected if the expected inflation increases while the nominal interest rate remains constant?

d. Given that the nominal interest rate canā€™t be negative ("zero lower bound"), what is the lowest value the real interest rate can be?

Using the graph and definitions below of the supply of loanable funds, SLF, and the demand for loanable funds, DLF, discuss the following:

a. What is meant by the equilibrium nominal rate of interest?

b. Illustrate and discuss how an autonomous increase in the expected rate of inflation will change the equilibrium nominal interest rate. Express your discussion in terms of the effect on the supply and demand for loanable funds. Consider an initial real rate of interest of 3 percent and an expected inflation rate of 3 percent. If the expected rate of inflation rises to 4 percent with the real interest rate constant, what would the resulting nominal interest rate become in equilibrium using the Fisher relationship? Assume that investors believe the rise in the expected rate of inflation will remain at the higher level indefinitely.

c. Starting from an equilibrium position as in a, discuss the effects of a tightening monetary policy if the markets believe that a Fed tightening will lower future (next period) inflation. How might a recession occur under this scenario? HINTS: Recall the Fisher relationship where (1+i) = (1+r)(1+pe), where i is the nominal interest rate, r is the required real rate of return before taxes, and pe is the expected rate of inflation.