Monday, December 28, 2009

Two-Minute Drill Real Interest Rates

Summary: Calculate the real interest rate. Interpret the results.

While reading the Wall Street Journal, you note that the interest rates on 1-year Treasuries are 8%. You expect inflation to be 2% over the next year. What is the real interest rate?

The real interest rate equals the nominal interest rate minus the expected rate of inflation. In my example, the real interest rate equals 6% (8% - 2%).

A real interest rate of 6% means that if I forgo $1 in spending today, I'll be able to consume $1.06 in the future. Remember to use the real interest rate, r, on the vertical axis when plotting the Loanable Funds Market.

Extra Credit: Can you show that 1+r = (1 + i) / (1 + e) is roughly equivalent to r = i - e? Assume that i is the nominal interest rate and e is the expected rate of inflation.

About the Author: Mike Fladlien is an AP Economics teacher from Muscatine High School in Muscatine, IA. He is currently working on a model to easily teach the Loanable Funds Market in AP Macroeconomics classes.


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