Wednesday, January 13, 2010

Where's the Economics?

Summary: Real interest rate.

There are many interest rates in the economy, but they all move together. The nominal interest rate is expressed as a percent on savings accounts, money markets accounts, and securities. In this graphic, I show the price of goods and services deflated into 2005 dollars. What is the difference between the real GDP and the nominal interest rate?

The difference has to be expected inflation. In AP Macroeconomics, the real interest rate, r, is found by subtracting the expected rate of inflation from the nominal interest rate, i. Adding the real interest rate to the expected rate of inflation would equal the nominal interest rate. The image above can be enlarged simply by clicking on it.

How do you form inflationary expectations? Suppose you see the Central Bank increasing the money supply. Assuming that output is constant at the natural rate of unemployment, you would assume that the price level would increase. If the money supply is constant, then consumers will demand more money and interest rates will rise. This is the Fisher Effect.

About the Author: Mike Fladlien is an AP Economics teacher from Muscatine High School in Muscatine, IA.


Patti said...

this is nice and simple. Thanks!
Patti Brazill
Irondequoit high School
Rocheseter, NY

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