Inflation And Interest Rates

Inflation and Interest Rates

Interest Rate Real and Nominal Interest Rates Nominal Interest Rates (i) Interest Rates expressed in current dollar terms. Real Interest Rates (r) Nominal Interest Rate adjusted for inflation. Example:

The relationship between Inflation, Real and Nominal Interest Rates Fisher Equation: i=r+π or i = r + πe or r = i – πe The quantity theory shows that the rate of money growth determine the rate of inflation. and the fisher equation tells us to add the real interest rate and inflation together will determine the nominal interest rate. An increase in the rate of money growth of 1 per cent cause a 1 per cent increase in the inflation rate.and a 1 per cent increase in the rate of inflation cause a 1 per cent increase in the nominal interest rate.

Inflation and Nominal Interest Rate

Real and Nominal Interest Rates

Real and Nominal Interest Rates

ex ante real interest rate and ex post real interest rate • Ex ante real interest rate: the real interest rate the borrower and lender expect when the loan is made • Ex post real interest rate: the real interest rate actually relized. • Ex ante real interest rate: i = r + πe • Ex post real interest rate: i = r + π

The Nominal Interest Rate and Demand for Money • The nominal interest rate is the opportunity cost of holding money • comparing the real returns on alternative asset such as bond • Demand for money depends on the price of holding money • Hence, demand for real money depends on both the level of income and the nominal interest rate. • General money demand function:

The Nominal Interest Rate and Demand for Money • Money demand fuction: • Back to the fisher eq; • i = r + πe • Rearrange The Money Demand function:

Money, Price and Interest Rate

The Cost of Inflation • It hurts my real buying power and makes me poorer. • The distortion of inflation tax on the amount of money people hold.  a higher inflation rate leads a higher nominal interest rate  leads to lower real money balances • High inflation induces firm to change their posted prices more often. • The higher inflation rate, the greater the variability in relative prices. • Inconvence of living in a world with a changing in price level. • it arbitrarily redistributes wealth among individuals. • Unanticipated inflation also hurts individuals on fixed pensions

Benefit of Inflation • some inflation may make labor markets work better. • an increase in supply or decrease in demand leads to a fall in the equilibrium real wage for a group of workers. • If nominal wages can’t be cut,then the only way to cut real wages is to allow inflation to do the job.Without inflation, the real wage will be stuck above the equilibrium level, resulting in higher unemployment. greases the wheels” of labor markets

Hyperinflation • Hyperinflation is often defined as inflation that exceeds 50 percent per month, which is just over 1 percent per day. • During hyperinflations, most of the costs of inflation become severe. Hyperinflations typically begin when governments finance large budget deficits by printing money. They end when fiscal reforms eliminate the need for seigniorage

• According to classical economic theory, money is neutral: the money supply does not affect real variables. Therefore, classical theory allows us to studyhow real variables are determined without any reference to the money supply. • The equilibrium in the money market then determines the price level and, as a result, all other nominal variables.This theoretical separation of real and nominal variables is called the classical dichotomy.

The Cagan Model: How Current and Future Money Affect the Price Level