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ECON-200 Lecture Notes - Lecture 16: Nominal Interest Rate, Loanable Funds, Real Interest Rate

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School
Diablo Valley College
Department
Economics
Course
ECON-200
Professor
Sorce

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Document Summary

Interest represents a payment in the future for a transfer of money in the past. The nominal interest rate (i) is the interest rate usually reported and not corrected for inflation. It is the interest rate that a bank pays or asks for. The real interest rate (r) is the nominal interest rate that is corrected for the effects of inflation: r = i inflation. Expected vs realized (ex ante vs ex post) A budget deficit decreases the supply of loanable funds. Shifts the supply curve to the left. Reduces the equilibrium quantity of loanable funds. The move from point a to c is in fact a combination of three movements, occurring at the same time. Important distinction: move of a curve vs move along a curve. The latter is only due to the change of the variable on the y axis. The former is due to some other variables, not the y axis variable to b.

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Related Questions

1. Nominal and real interest rates: 

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

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

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

 

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 can’t be negative ("zero lower bound"), what is the lowest value the real interest rate can be?

Suppose I borrow $200,000 for one year at a fixed nominal interest rate of 7 percent.

(a) What is my nominal repayment next year?

(b) Suppose that at the time the loan was made, both the lender and I believed that the (ex-ante) rel interest rate on the loan would be two percent. Suppose the actual inflation rate over the life of the loan turns out to be 4 percent. What is the ex-post real interest rate? Does the inflation rate help me at the expense of the lender, or help the lender at my expense?

(c) Re-do question (b) assuming that the inflation rate turns out to be 5 percent and 6 percent.

(d) Given that the lender and I agreed that the ex-ante real interest rate should be 2 percent, what nominal interest rate would I have been charged if the lender and I had expected inflation over the life of the loan to be 10 percent? 3 percent? 0 percent?

(e) Inflation increased enexpectedly during the 1970s. Explain why this helped someone who bought a house using a 30-year mortgage with fixed nominal interest rates in 1965, but not someone who bought a house using a 30-year mortgage with a fixed nominal interest rate in 1980.

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.