Transcript Real interest rate

NOMINAL AND REAL VALUES
Nominal and Real Values in Macroeconomics
Macroeconomics makes a big issue of the distinction
between nominal values and real values:
• Nominal GDP and real GDP
• Nominal wage rate and real wage rate
• Nominal interest rate and real interest rate
NOMINAL AND REAL VALUES
 Just because you get an increase in the nominal value,
doesn’t mean you are better off than you were before.
 We will need to deflate nominal values by the price index
to calculate real values for anything- Wages, Income,
GDP, etc…
Formula for Real Values
Nominal
__________________
Real =
X 100
Price Index
* The price index can be the CPI, PPI,
or the GDP Deflator.
NOMINAL AND REAL VALUES
Nominal and Real Wage Rates
Nominal wage rate
The average hourly wage rate measured in current
dollars.
Real wage rate
The average hourly wage rate measured in the dollars
of a given reference base year. Reflects inflation!
NOMINAL AND REAL VALUES
What is the nominal hourly wage of $14.28 in 2002 worth in
1982-1984 dollars.
To calculate the real wage rate, we divide the nominal
wage rate by the CPI and multiply by 100.
That is,
Nominal wage rate in 2002
Real wage rate in 2002 =
x 100
CPI in 2002
$14.68
x 100 = $8.16
Real wage rate in June 2002 =
179.9
So the $14.28 in the nominal hourly wage in 2002 is
worth $8.16 in 19821984 dollars.
22.3 NOMINAL AND REAL VALUES
Figure 22.4 shows
nominal and real wage
rates: 1975–2005.
The nominal wage rate
has increased every year
since 1975.
The real wage rate
increased briefly during
the late 1970s, decreased
through the mid-1990s,
and then increased
slightly.
Nominal and Real Income
Example:
2002- Nominal income is $40,000
2003- Nominal Income is $41,000
2002- CPI 181.6
2003- CPI 185
Q. 1- What is my real income for each year?
Q. 2- Did my purchasing power increase in
2003? Am I better off in 2003?
Nominal and Real Income
 2002 Real Income= $40,000/181.6 x 100= $22,026
 2003 Real Income= $41,000/185 x 100= $22,162
 Real income has increased by $136. You are better
off in 2003 than in 2002.
Nominal and Real Income
What if your income only increased to
$40,500 in 2003.
Calculate: 1) Real income for each year.
2) Did your purchasing power
increase in 2003?
Nominal and Real Income
 2002 Real Income= $40,000/181.6 x 100= $22,026
 2003 Real Income= $40,500/185 x 100= $21,891
 Real income has decreased by $135. So even though
your nominal income has increased by $500, your
real income has decreased by $135.
Inflation
Anticipated Versus Unanticipated Inflation
The effects of inflation on individuals depends upon
which type of inflation exists.
Anticipated Inflation
Anticipated Inflation
The rate of inflation that the majority of individuals
believe will occur. If the rate of inflation is 10% and that
is what the majority expected, then inflation was fully
anticipated.
Unanticipated Inflation
Unanticipated Inflation
Inflation that comes as a surprise to individuals in the
economy. If people expected an inflation rate of 5% and
the actual rate of inflation was 10%, then 5% of the
actual inflation rate was unanticipated inflation.
This is the inflation that wreaks havoc on the economy!
Unanticipated inflation hurts many people. When
inflation is anticipated some of these people (lenders)
are able to protect themselves.
All of this is important when dealing with interest rates!
22.3 NOMINAL AND REAL VALUES
Nominal and Real Interest Rates
Nominal interest rate
The percentage return on a loan expressed in todays
dollars.
Real interest rate
The percentage return on a loan, calculated by purchasing
power—the nominal interest rate adjusted for the effects of
inflation.
Real interest rate = Nominal interest rate – Inflation rate
Inflation/Interest Rates
Real Interest Rate
1982 -- Home Mortgage
• Nominal Interest Rate 15%
• Increase in the price of housing of 25% (inflation)
Real Rate = 15% - 25% = -10%
Inflation/Interest Rates
Real Interest Rate
1998 -- Home Mortgage
• Nominal Interest Rate 6.5%
• Increase in the price of housing of 2%
Real Rate = 6.5% - 2% = 4.5%
Question
Which scenario is the best for the lender? the borrower?
Does Inflation Necessarily Hurt Everyone?
 All of this is extremely important with borrowers and
creditors.
 Banks must anticipate the inflation rate to cover all loans.
Try to increase interest rates with the rate of inflation.
This is not an exact science. Creditors/lenders must
make sure that the nominal rate of interest is greater
than anticipated inflation. It is the unanticipated inflation
they can not predict.
Creditor gains if real interest rate is positive.
Debtor gains if real rate of interest is negative
Unanticipated inflation is the key!!
Higher unanticipated inflation helps borrowers/hurts
creditors.
Does Inflation Necessarily Hurt Everyone?
Nom. Int. Rate - Infl. Rate =
10%
5%
10%
10%
10%
15%
Real Int. Rate
5% creditor wins
0% draw
-5% debtor wins
In the past inflation and nominal interest have risen and
fallen together.
Effects of Inflation
 Creditors (Lenders) Lose: Net creditors are individuals
or businesses that have more savings than debt. A net
creditor receives interest and, therefore, receives a
reduced real interest return when there is unanticipated
inflation.
 Debtors (borrowers) Win: Net debtors are individuals
or businesses that have more debt than savings. A net
debtor pays interest, and therefore, pays a lower real
interest rate when there is unanticipated inflation. A fixed
rate of interest helps a debtor in the long term. Paying
back a loan with less purchasing power during times of
inflation.
NOMINAL AND REAL VALUES
Figure shows real and
nominal interest rates:
1965–2005.
During the 1970s,
the real interest rate
became negative.
The nominal interest
rate increased during
the high-inflation 1980s.
Inflation
Protecting Against Inflation
Cost-of-living adjustments (COLAs)
• Clauses in contracts that allow for increases in
specified nominal values to take account of
changes in the cost of living
ARMS- Banks offer “Adjustable Rate Mortgages” that
adjust the interest rate to keep up with changes in
inflation
2
Types of Inflation
Demand- Pull Inflation- More dollars chasing
less goods. An increase in aggregate demand.
Often results for too much money in the
economy.
Cost-Push Inflation- Inflation due to an
increase in production/ input costs. Results in a
decrease of aggregate supply.