Transcript Interest Rates & Inflation

Interest Rates & Inflation
Real vs. Nominal Interest Rates
Interest Rates
• Reflects the cost of borrowing money (or benefit of saving it!)
– There are short term & long term interest rates
• Low interest rates are critical for a healthy economy (GDP)
– As interest rates ↑ => cost of borrowing money ↑ => Investment (I) ↓
Short Term Interest Rates
• The Federal Reserve only “controls” short term interest rates
– Used by banks & currently = 0.0%
• Federal Funds Rate changes over time to regulate GDP & inflation
Long Term Interest Rates
• Long term interest rates are determined by inflation expectations
– Currently = 2.50% (10-year government bond)
• As Expected Inflation ↑ => long term interest rates ↑
• Bond prices move inverse to interest rates.
– bond prices ↓ => interest rate ↑
Investments & Inflation
• Inflation directly affects your real return on any investment
• If a bond pays 2.5% interest, what is your real return?
“It Depends” on the rate of inflation!
Adjusting Interest Rates for Inflation
Nominal Interest Rate = Real Interest Rate + Expected Inflation
Reworking above formula:
Real = Nominal – Expected Inflation
10-year Gov’t Bond Purchase
Nominal Interest Rate
Nominal dollars per year:
In 10-years:
$1,000,000
2.50%
$25,000 (interest per year)
$1,000,000 principal paid back
If expected inflation = 2.0%:
• The real interest rate is 0.5% (2.5% - 2%)
• Purchasing Power ↑ $5,000 per year
Practice Test #3