Inflation: Interest rates Flashcards
Chapter 6
What are the two types of interest rates in macroeconomics?
The nominal interest rate and the real interest rate.
What does the nominal interest rate represent?
The rate stated by banks — the percentage increase in your money in dollar terms.
What does the real interest rate represent?
The increase in your purchasing power, after adjusting for inflation.
Why doesn’t your purchasing power rise by the full nominal interest rate?
Because inflation reduces the value of money, so your money buys less than before.
What happens if inflation is higher than the nominal interest rate?
Purchasing power falls — the real interest rate is negative.
What is the formula linking real, nominal, and inflation rates?
r=i−π
r = real interest rate
i = nominal interest rate
π = inflation rate
If i = 8% and π = 5%, what is r?
r=8%−5%=3%
If inflation is 0% and nominal interest rate is 4%, what is the real return?
r=4%
If nominal interest rate is 6% and inflation is 6%, what happens to purchasing power?
It stays the same — real interest rate is 0%.
Why is the real interest rate important to savers and investors?
It shows the true return on savings/investments after accounting for inflation.
What is the formula for the Fisher equation?
i=r+π
i = nominal interest rate r = real interest rate π = inflation rate
What does the Fisher equation show about nominal interest rates?
That the nominal interest rate equals the real interest rate plus the inflation rate.
How does inflation affect nominal interest rates in the Fisher Effect?
A 1% increase in inflation leads to a 1% increase in the nominal interest rate, assuming the real rate stays constant.
What does the quantity theory of money say about inflation?
That increases in money growth cause proportional increases in inflation.
If the real interest rate is 2% and inflation is 4%, what is the nominal interest rate?
i=2%+4%=6%
What happens to the nominal interest rate if inflation rises by 1%?
The nominal interest rate also rises by 1%, according to the Fisher Effect.
Why is the Fisher Effect important for monetary policy?
It shows how expected inflation affects nominal interest rates, which central banks consider when setting policy.
What is the one-for-one relationship described by the Fisher Effect?
A 1% increase in inflation causes a 1% increase in the nominal interest rate.
Does the Fisher Effect assume real interest rates change with inflation in the long run?
No — it assumes real interest rates are determined by real economic factors and stay stable in the long run.
What is correlation between nominal and real interest rates?
High correlation, 0.63
What does the ex ante real interest rate measure?
It measures the expected real return when a loan is made, based on the expected rate of inflation.
What does the ex post real interest rate measure?
It measures the actual real return after inflation is realized — how much purchasing power truly increased.
Why do ex ante and ex post real interest rates differ?
Because expected inflation may differ from actual inflation — and borrowers/lenders can’t know future inflation with certainty.
What is the formula for the ex ante real interest rate?
r=i−Eπ
Where EπEπ is expected inflation
