Thursday, February 11, 2010

Real Interest Rates

Summary: Two-minute drill. Fisher effect.

Using the equation for calculating real interest rate, r, to complete the problems below. In this drill, i, equals the nominal interest rate, and e equals the expected rate of inflation.

1. i = 8; e = 2; r = ?

2. i = 8; e = ?; r = 10

3. i = ?; e = 7; r = 6

4. i = 3; e = 1l r = 2

Using the AP Macroeconomics formula, r = i - e the answers are: 6,-2,13, and 2. Sure looks like borrowing was really expensive in problem 2.

When I explain nominal interest rates, I tell the students that this is the rate posted by a bank. It is the rate you'll find in the newspaper. Nominal means in terms of money or currency. The real interest rate is measured in a basket of goods. So the real interest rate measures how much you'll repay in a basket of goods. When inflation is high, you'll be repaying the loan, by the repayment buys less goods than when the loan was made.

Is inflation bad? My answer is it depends. Inflation has winners and losers. If a bank extends a fixed rate loan and unanticipated inflation catches the bank off guard, then the bank is hurt but the debtor is helped. So inflation would be bad for the bank but good for the debtor. The economy overall is neither hurt or helped.

About the Author: Mike Fladlien is an AP Economics teacher from Muscatine High School in Muscatine, IA. He is an author, and also publishes the Mikeroeconomics and iMacroeconomics VB blogs.


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