Inflation and Interest Rates

Interest Rate

Real and Nominal Interest Rates

Nominal Interest Rates (i)
Interest Rates expressed in current dollar
terms.
Real Interest Rates (r)
Nominal Interest Rate adjusted for
inflation.
Example:
The relationship between Inflation,
Real and Nominal Interest Rates
Fisher Equation:
i=r+π
or
i = r + πe
or
r = i – πe

The quantity theory shows that the rate of money growth determine
the rate of inflation. and the fisher equation tells us to add the real
interest rate and inflation together will determine the nominal
interest rate.
An increase in the rate of money growth of 1 per cent cause a 1 per
cent increase in the inflation rate.and a 1 per cent increase in the
rate of inflation cause a 1 per cent increase in the nominal interest
rate.
Inflation and Nominal Interest Rate
Real and Nominal Interest Rates
Real and Nominal Interest Rates
ex ante real interest rate and ex
post real interest rate
• Ex ante real interest rate: the real interest rate
the borrower and lender expect when the loan is
made
• Ex post real interest rate: the real interest rate
actually relized.
• Ex ante real interest rate: i = r + πe
• Ex post real interest rate: i = r + π
The Nominal Interest Rate and
Demand for Money
• The nominal interest rate is the opportunity cost of holding
money
• comparing the real returns on alternative asset such as
bond
• Demand for money depends on the price of holding money
• Hence, demand for real money depends on both the level
of income and the nominal interest rate.
• General money demand function:
The Nominal Interest Rate and
Demand for Money
• Money demand fuction:

• Back to the fisher eq;

• i = r + πe
• Rearrange The Money Demand function:
Money, Price and Interest Rate
The Cost of Inflation
• It hurts my real buying power and makes me poorer.
• The distortion of inflation tax on the amount of money people hold.
 a higher inflation rate leads a higher nominal interest rate
 leads to lower real money balances
• High inflation induces firm to change their posted prices more
often.
• The higher inflation rate, the greater the variability in relative
prices.
• Inconvence of living in a world with a changing in price level.
• it arbitrarily redistributes wealth among individuals.
• Unanticipated inflation also hurts individuals on fixed pensions
Benefit of Inflation
• some inflation may make labor markets work better.
• an increase in supply or decrease in demand leads to a
fall in the equilibrium real wage for a group of workers.
• If nominal wages can’t be cut,then the only way to cut
real wages is to allow inflation to do the job.Without
inflation, the real wage will be stuck above the
equilibrium level, resulting in higher unemployment.
greases the wheels” of labor markets
Hyperinflation
• Hyperinflation is often defined as inflation that
exceeds 50 percent per month, which is just over
1 percent per day.
• During hyperinflations, most of the costs of
inflation become severe. Hyperinflations typically
begin when governments finance large budget
deficits by printing money. They end when fiscal
reforms eliminate the need for seigniorage
• According to classical economic theory, money is neutral:
the money supply does not affect real variables. Therefore,
classical theory allows us to studyhow real variables are
determined without any reference to the money supply.
• The equilibrium in the money market then determines the
price level and, as a result, all other nominal variables.This
theoretical separation of real and nominal variables is called
the classical dichotomy.
The Cagan Model: How Current and
Future Money Affect the Price Level