Interest Rates Flashcards
What is inflation?
It is the increase in general price level.
How is inflation measured?
Usually measured by the increase in price of a representative basket of goods and services as an index
CONSUMER PRICE INDEX (CPI) / PRODUCER PRICE INDEX (PPI)
Equation found in notes
- Can find the realised/historical inflation (backward looking)
OR
- Find the expected inflation (forward looking)
What is a nominal interest rate?
The reported interest rate that one would observe in the market.
- Increases with inflation
WHY?
– Lenders demand higher returns to cover for the loss of purchasing power due to inflation, thus i/r increase with inflation
*Nominal rate (approximation) = Real rate + Inflation
What is a real interest rate?
The interest rate after netting off the effect of inflation. (Excludes inflation)
WHY EXCLUDE?
- Different economies have different rates of inflation
> Real interest rate serves as a means of comparing the cost of borrowing between economies
- Same economy but inflation rate is different at different point of time
> As we look at the real cost of operations, we can compare over time (within the same economy).
What is the Fisher Equation (without tax)?
(1 + nominal rate) = (1 + real rate) (1 + inflation rate)
(1 + i) = (1 + r) (1 + p)
i = r + p + rp
Since rp is small: Nominal rate (approximation) = Real rate + Inflation
What is the Fisher Equation (with tax)?
[1 + (1 - t)i] = [1 + (1 - t)r] (1 + p)
*Tax is on the nominal and real i/r, NOT on (1 + i) and (1 + r)
Why are the nominal and real interest rates taxed?
Interest earnings are taxable
Note: Interest Tax Shields can exist
What are the 4 types of Inflation?
1) Headline Inflation
2) Core Inflation
3) Expected Inflation
4) Deflation
What is Headline Inflation?
Total inflation of an economy
- Includes volatile items (Food & Energy)
- May not necessarily reflect the current state of the economy/Underlying pressures on inflation
> As they fluctuate too much, this may cause inaccurate policy-making to target inflation
How does Core Inflation works?
Normally: Exclude items such as Food & Energy as they are volatile
- As they fluctuate too much, this may cause inaccurate policy-making to target inflation
- This is because it roughly takes 6 months to see changes in i/r rate after modifying the policy
What does Singapore exclude from its Core Inflation?
1) Accommodation
2) Private Transport
Known as the MAS Underlying Inflation.
If these 2 are included in Singapore’s Core Inflation, our inflation will be very high.
WHY?
Demand for land space is high but there is limited land/road space. Thus, prices for accommodation and private transport will be very high, driving inflation up.
How does Expected Inflation works?
Need to be carefully managed (Sometimes market sentiments may be wrong)
1) Brings forward purchasing
(People expect prices to increase, thus purchase now, driving prices up)
2) Brings forward investments in properties and commodities
(Will drive inflation up)
3) Demand higher wages
(Since inflation goes up, employees would want more wages to tackle the decrease in purchasing power –> This will cause cost of businesses to increase, causing the costs of companies’ goods and services to increase, thus price of g&s to increase, driving inflation)
4) Can cause businesses to pool their funds to invest out of the country as well since they are expecting increasing inflation
Becomes a self-fulfilling prophecy as these can fuel actual inflation.
What should the government do to target inflation?
Signal to the market to bring down inflation by:
1) Increasing interest rate/fed fund rate to double digits
○ But not going to do this first, because this is a rumour and may act prematurely.
2) Say that government will increase taxes if its real inflation
3) Talk down inflation (what most politicians do)
○ Assure the public/market to influence their decisions
NOTE: Government have to be reliable and credible in the first place
What is Deflation?
Opposite of inflation
Happens with Quantitative Easing. (More money supply, lower interest rates)
Example: Japan for the last 20 years
Why does Deflation happen?
1) Delay purchasing and investing decisions
- Buy less, companies will slow down production –> Result in more layoffs/salary reductions –> These workers will then reduce their consumption and buy less –> Driving prices down AGAIN
* Self-fulfilling and recessionary
2) Past debt becomes more difficult to service
- Value of assets fall BUT Value of loans to repay either increase or stay constant
Example: The price of house falls but loans that are taken to buy the house remain the same. Past debts become more difficult to service –> (1) Delay purchasing and investment decisions
3) Real interest rate can be relatively too high
- Real cost of borrowing increases
- (1) Delay purchasing and investment decisions (CYCLE)
