real interest rates

Examples of real interest rates in the following topics:

• Distribution Effects of Inflation

  • This is because the inflation rate is built in to the nominal interest rate, which is the sum of the real interest rate and expected inflation.
  • For example, if the real cost of borrowing money is 3% and inflation is expected to be 4%, the nominal interest rate on a loan would be 7%.
  • The lower purchasing power of money erodes the value of currency, and inflation reduces the real interest rate earned on bonds.
  • Debtors find themselves paying a lower real interest rate than expected, and stocks tend to rise in value to reflect the inflation level.
  • Part of the reason that lenders charge interest is to recoup the cost of inflation over time.

• Crowding-Out Effect

  • What happens is that an increase in the demand for loanable funds by the government (e.g. due to a deficit) shifts the loanable funds demand curve rightwards and upwards, increasing the real interest rate.
  • A higher real interest rate increases the opportunity cost of borrowing money, decreasing the amount of interest-sensitive expenditures such as investment and consumption.
  • If an increase in government spending and/or a decrease in tax revenues leads to a deficit that is financed by increased borrowing, then the borrowing can increase interest rates, leading to a reduction in private investment.
  • If the economy is at capacity or full employment, then the government suddenly increasing its budget deficit (e.g., via stimulus programs) could create competition with the private sector for scarce funds available for investment, resulting in an increase in interest rates and reduced private investment or consumption.
  • When crowding-out occurs, the Investment-Savings (IS) curve moves to the right, causing higher interest rates (i) and expansion in the "real" economy (real GDP, or Y).

• The Federal Reserve and the Financial Crisis of 2008

  • Lower interest rates stimulate loans, spending, and investment and help an economy escape from recession.
  • The zero lower bound refers to the fact that the central bank cannot push nominal interest rates below 0%.
  • When inflation is high, however, central banks may be able to push the real interest rate below 0%.
  • Recall that the nominal interest rate is the sum of the real interest rate and the expected inflation rate.
  • If the nominal interest rate is 1% and inflation is 3%, the real interest rate is -2%.

• Relationship Between Expectations and Inflation

  • Suppose you are opening a savings account at a bank that promises a 5% interest rate.
  • This is the nominal, or stated, interest rate.
  • The real interest rate would only be 2% (the nominal 5% minus 3% to adjust for inflation).
  • The difference between real and nominal extends beyond interest rates.
  • Consequently, employers hire more workers to produce more output, lowering the unemployment rate and increasing real GDP.

• The Demand for Money

  • Specific to the liquidity function, L(R,Y), R is the nominal interest rate and Y is the real output.
  • However, when the demand for money is not stable, real and nominal interest rates will change and there will be economic fluctuations.
  • The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money that they borrow from a lender (creditor).
  • Interest-rate targets are a tool of monetary policy.
  • Relate the level of the interest rate to the demand for money

• Shifts in the Money Demand Curve

  • The interest rate is the price of money.
  • The quantity of money demanded increases and decreases with the fluctuation of the interest rate.
  • It shifts in with the nominal interest rate.
  • The nominal interest rate declines and there is a greater interest advantage in holding other assets instead of money.
  • The graph shows both the supply and demand curve, with quantity of money on the x-axis (Q) and the price of money as interest rates on the y-axis (P).

• The Taylor Rule

  • Taylor's rule was designed to provide monetary policy guidance for how a central bank should set short-term interest rates.
  • The rule stipulates how much a central bank should change the nominal interest rate (real rate plus inflation) in response to changes in inflation, output, or other economic conditions.
  • The factors that the Taylor rule suggests taking into account when setting inflation-adjusted short-term interest rates are:
  • what the level of the short-term interest rate is that would be consistent with full employment.
  • The Taylor rule advocates setting interest rates relatively high (contractionary policy) when inflation is high or when the employment rate exceeds the economy's full employment level.

• Classical Theory

  • Classical theory, the first modern school of economic thought, reoriented economics from individual interests to national interests.
  • Classical theory reoriented economics away from individual interests to national interests.
  • Equality of savings and investment: classical theory assumes that flexible interest rates will always maintain equilibrium.
  • Calculating real GDP: classical theorists determined that the real GDP can be calculated without knowing the money supply or inflation rate.
  • Real and Nominal Variables: classical economists stated that real and nominal variables can be analyzed separately.

• Interest Rates and Economic Rationale

  • The interest rate is one of the primary influences on economic rationale.
  • The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money borrowed from a lender (creditor).
  • Interest rates also influence inflationary expectations.
  • For example, low interest rates can lead to large amounts of investments poured into the real-estate market and stock market.
  • The interest rates reached 14% in 1969 and lowered to 2% by 2003.

• The Slope of the Aggregate Demand Curve

  • Due to Pigou's Wealth Effect, the Keynes' Interest Rate Effect, and the Mundell-Fleming Exchange Rate Effect, the AD curve slopes downward.
  • As a result of Keynes' interest rate effect, Pigou's wealth effect, and the Mundell-Fleming exchange rate effect, the AD curve is downward sloping.
  • This will drive up interest rates and investments.
  • A vertical IS curve or a horizontal LM curve would essentially negate the way in which interest rates could affect aggregate demand.
  • Interest rates (i) are on the vertical axis, and output (y) is on the horizontal axis.