Pertemuan 13

Expectations:
Expectations: The
The
Basic
Basic Tools
Tools
CHAPTER 14
Prepared by:
Fernando Quijano and Yvonn Quijano
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
14-1 Nominal versus Real Interest Rates
 Interest Rates expressed in terms of dollars (or,

more generally, in units of the national currency)
are called nominal interest rates.
 Interest rates expressed in terms of a basket of

goods are called real interest rates.
Chapter 14: Expectations: The Basic Tools
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 2 of 32
Figure 14 - 1
Definition and Derivation
of the Real Interest Rate
it = nominal interest rate
for year t.
rt = real interest rate for
year t.
(1+ it): Lending one dollar
this year yields (1+ it)
dollars next year.
Alternatively, borrowing
one dollar this year implies
paying back (1+ it) dollars
next year.
Pt = price this year.
Pet+1= expected price next
year.
Pt Pt 1
Given 1  rt  (1  it ) e , and knowing that 
P t 1 P e
t  1 (1   e
t)
( P e
 Pt )
then, the expected rate of inflation equals  t 1 
e t 1
Pt
1  it
Consequently, (1  rt ) 
1   et + 1
If the nominal interest rate and the expected rate of inflation

are not too large, a simpler expression is:
rt  it   e
t +1
The real interest rate is (approximately) equal to the

nominal interest rate minus the expected rate of inflation.
rt  it   e
t +1
Here are some of the implications of the relation above:
 If  e t  0  it  rt
 If  e t  0  it  rt
 if it    e t   rt
Nominal and Real Interest Rates in the
United States since 1978
Figure 14 - 2
Nominal and Real One-
Year T-bill Rates in the
United States since 1978
Although the nominal interest
rate has declined considerably

since the early 1980s, the real
interest rate was actually
higher in 2006 than in 1981.
14-2 Nominal and Real Interest Rates and
the IS–LM Model
 When deciding how much investment to undertake,

firms care about real interest rates. Then, the IS
relation must read:
Y  C(Y  T )  I (Y , r )  G
 The interest rate directly affected by monetary policy—

the one that enters the LM relation—is the nominal

interest rate, then:
M
 YL(i )
P
The real interest rate is: r  i e
14-2 Nominal and Real Interest Rates and
the IS–LM Model
Note an immediate implication of these three relations:
 The interest rate directly affected by monetary policy is

the nominal interest rate.
 The interest rate that affects spending and output is the

real interest rate.
 So, the effects of monetary policy on output depend on

how movements in the nominal interest rate translate
into movements in the real interest rate.
14-3 Money Growth, Inflation, and Nominal
and Real Interest Rates
This section focuses on the following assertions:
 Higher money growth leads to lower nominal interest

rates in the short run, but to higher nominal interest
rates in the medium run.
 Higher money growth leads to lower real interest

rates in the short run, but has no effect on real

interest rates in the medium run.
Revisiting the IS–LM Model
Reducing the IS relation, LM relation and relation between

the real and nominal interest rate gives us:
IS Y  C(Y  T )  I (Y , i   e )  G
M
LM  Y L(i )
P
 The IS curve is still downward sloping.
 The LM curve is upward sloping.
 The equilibrium is at the intersection of the IS curve
and the LM curve.
Revisiting the IS–LM Model
Figure 14 - 3
Equilibrium Output and
Interest Rates
The equilibrium level of output
and the equilibrium nominal
interest rate are given by the
intersection of the IS curve and

the LM curve. The real interest
rate equals the nominal interest
rate minus expected inflation.
If r  i   e   r   i    e
If  e is constant,   e  0   r   i
Nominal and Real Interest Rates in the Short Run
Figure 14 - 4
The Short-Run Effects of
an Increase in Money
Growth
An increase in money growth
increases the real money stock
in the short run. This increase

in real money leads to an
increase in output and
decreases in both the nominal
and real interest rates.
Nominal and Real Interest Rates in the Medium Run
 In the medium run, output returns to the natural

level of output, Yn .
 In the medium run, the rate of inflation is equal

to the rate of money growth minus the rate of
growth of output.
Nominal and Real Interest Rates in the Medium Run
In the medium run, the nominal interest rate increases

one for one with inflation. This result is known as the
Fisher effect, or the Fisher Hypothesis.
For example, an increase in nominal money growth of

10% is eventually reflected by a 10% increase in the rate
of inflation, a 10% increase in the nominal interest rate,

and no change in the real interest rate.
i  rn  gm
From the Short Run to the Medium Run
In the short run, lower nominal interest rates lead to higher output
and inflation. In the medium run, this situation changes.
In the short run, r  rn  Y  Yn  u  un   
Over time,    Eventually   g' m  ( g' m   )  0  i 

In the medium run, r  rn

Y  Yn
u  un
  gm
i  rn  gm
In words:
 So long as the real interest rate is below the natural real

interest rate, output is higher than the natural level of
output, and unemployment is below its natural rate.
 From the Phillips curve relation, we know that as long as

unemployment is below the natural rate of unemployment,
inflation increases.
 As inflation increases, it becomes higher than nominal

money growth, leading to negative real money growth.
 In the medium run, the real interest rate increases back to

it initial value.
Figure 14 - 5
The Adjustment of the
Real and the Nominal
Interest Rates to an
Increase in Money
Growth
An increase in money growth

leads initially to decreases in
both the real and the nominal
interest rates. Over time,
however, the real interest rate
returns to its initial value, and
the nominal interest rate
converges to a new higher
value, equal to the initial value
plus the increase in money
growth.
Evidence on the Fisher Hypothesis
To see if increases in inflation lead to one-for-one

increases in nominal interest rates, economists look at:
 Nominal interest rates and inflation across countries.

The evidence of the early 1990s finds substantial
support for the Fisher hypothesis.
 Swings in inflation, which should eventually be

reflected in similar swings in the nominal interest rate.
Again, the data appears to fit the hypothesis quite
well.
Nominal Interest Rates and Inflation across Latin
America in the Early 1990s
Figure 1 Nominal Interest Rates and Inflation in Latin

America, 1992 to 1993
Figure 14 - 6
The Three-Month
Treasury Bill Rate and
Inflation since 1927
The increase in inflation from
the early 1960s to the early
1980s was associated with an

increase in the nominal interest
rate. The decrease in inflation
since the mid-1980s has been
associated with a decrease in
Figure 14-6 has at least three interesting features:
 The steady increase in inflation from the early 1960s

to the early 1980s was associated with a roughly
parallel increase in the nominal interest rate.
 The nominal interest rate lagged behind the increase

in inflation in the 1970s, while the disinflation of the
early 1980s was associated with an initial increase in
 The other episode of inflation underscores the

importance of the “medium-run” qualifier in the
Fisher hypothesis.
14-4 Expected Present Discounted Values
Interest Rates
The expected present discounted value of a sequence

of future payments is the value today of this expected
sequence of payments.
Computing Expected Present Discounted Values

Figure 14 - 7
Computing Present
Discounted Values
Interest Rates
(a) One dollar this year is worth (c) One dollar is worth (1  it )(1  it 1 )
1+it dollars next year. dollars two years from now.
(b) If you lend/borrow 1/(1+it) (d) The present discounted value of

dollars this year, you will a dollar two years from today is
receive/repay 1 equal to 1 .
(1  it )  1
(1  it (1  it )(1  it 1 )
dollar next year.
Interest Rates
The word “discounted” comes from the fact that the

value next year is discounted, with (1+it) being the
discount factor. The 1-year nominal interest rate, it, is
sometimes called the discount rate.
Interest Rates
The General Formula
The present discounted value of a sequence of payments, or
value in today’s dollars equals:
1 1
$Vt  $ zt  $ zt 1  $ zt  2    
(1  it ) (1  it )(1  it 1 )
When future payments or interest rates are uncertain, then:
1 1
$Vt  $ zt  $ z t 1 
e
$ z e
t2    
(1  it ) (1  it )(1  i t 1 )
e
Present discounted value, or present value are another

way of saying “”expected present discounted value.”
Interest Rates
Using Present Values: Examples
This formula has these implications:
 Present value depends positively on today’s

actual payment and expected future payments.
 Present value depends negatively on current

and expected future interest rates.
Interest Rates
Constant Interest Rates
To focus on the effects of the sequence of payments on the
present value, assume that interest rates are expected to be
constant over time, then:
1 1
$Vt  $ zt  $ z t 1 
e
$ z e
t 2    
(1  i ) (1  i ) 2
Constant Interest Rates and Payments

When the sequence of payments is equal—called them $z, the
present value formula simplifies to:
 1 1 
$Vt  $ z 1     n 1 
 (1  i ) (1  i ) 
Interest Rates
Constant Interest Rates and Payments
The terms in the expression in brackets

represent a geometric series. Computing the
sum of the series, we get:
1  [1 / (1  i ) n ]
$Vt  $z
1  [1 / (1  i )]
Interest Rates
Constant Interest Rates and Payments, Forever
Assuming that payments start next year and go on forever,
then:
1 1 1  1 
$Vt  $z  2 $z       1     $z
(1  i ) (1  i ) (1  i )  (1  i ) 
Using the property of geometric sums, the present value

formula above is:
1 1
$Vt  $z
(1  i ) 1  (1/(1  i ))
$z
Which simplifies to: $Vt 
i
Interest Rates
Zero Interest Rates
If i = 0, then 1/(1+i) equals one, and so does (1/(1+i)n) for

any power n. For that reason, the present discounted
value of a sequence of expected payments is just the
sum of those expected payments.
Interest Rates
Nominal versus Real Interest Rates and Present Values
1 1
$Vt  $ zt  $ z t 1 
e
$ z e
t2    
(1  it ) (1  it )(1  i t 1 )
e
Replacing nominal interest with real interest rates to obtain

the present value of a sequence of real payments, we get:
1 1
Vt  zt  z t 1 
e
z e
t2    
(1  rt ) (1  rt )(1  r t 1 )
e
$Vt
Which can be simplified to:  Vt
Pt
Key Terms
 nominal interest rate

 real interest rate
 Fisher effect, Fisher hypothesis,
 expected present value
 discount factor
 discount rate
 present discounted value
 present value

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Expectations:

 Interest Rates expressed in terms of dollars (or,

 Interest rates expressed in terms of a basket of

If the nominal interest rate and the expected rate of inflation

The real interest rate is (approximately) equal to the

Here are some of the implications of the relation above:

rate has declined considerably

 When deciding how much investment to undertake,

 The interest rate directly affected by monetary policy—

the one that enters the LM relation—is the nominal

The real interest rate is: r  i e

Note an immediate implication of these three relations:

 The interest rate directly affected by monetary policy is

 The interest rate that affects spending and output is the

real interest rate.

 So, the effects of monetary policy on output depend on

 Higher money growth leads to lower nominal interest

 Higher money growth leads to lower real interest

rates in the short run, but has no effect on real

Reducing the IS relation, LM relation and relation between

intersection of the IS curve and

in the short run. This increase

 In the medium run, output returns to the natural

 In the medium run, the rate of inflation is equal

In the medium run, the nominal interest rate increases

For example, an increase in nominal money growth of

of inflation, a 10% increase in the nominal interest rate,

In the short run, r  rn  Y  Yn  u  un   

Over time,    Eventually   g' m  ( g' m   )  0  i 

In the medium run, r  rn

 So long as the real interest rate is below the natural real

 From the Phillips curve relation, we know that as long as

 As inflation increases, it becomes higher than nominal

 In the medium run, the real interest rate increases back to

An increase in money growth

To see if increases in inflation lead to one-for-one

 Nominal interest rates and inflation across countries.

 Swings in inflation, which should eventually be

Figure 1 Nominal Interest Rates and Inflation in Latin

1980s was associated with an

Figure 14-6 has at least three interesting features:

 The steady increase in inflation from the early 1960s

 The nominal interest rate lagged behind the increase

 The other episode of inflation underscores the

The expected present discounted value of a sequence

Computing Expected Present Discounted Values

(b) If you lend/borrow 1/(1+it) (d) The present discounted value of

The word “discounted” comes from the fact that the

When future payments or interest rates are uncertain, then:

Present discounted value, or present value are another

This formula has these implications:

 Present value depends positively on today’s

 Present value depends negatively on current

and expected future interest rates.

Constant Interest Rates and Payments

The terms in the expression in brackets

Using the property of geometric sums, the present value

If i = 0, then 1/(1+i) equals one, and so does (1/(1+i)n) for

Replacing nominal interest with real interest rates to obtain

 nominal interest rate

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