Expectations: The Basic ToolsNominal Versus Real Interest RatesSlide 3Slide 4Slide 5Nominal and Real Interest Rates in the United States Since 1978Slide 7Expected Present Discounted ValuesComputing Expected Present Discounted ValuesSlide 10A General FormulaUsing Present Values: ExamplesConstant Interest RatesConstant Interest Rates and PaymentsConstant Interest Rates and Payments, Going on ForeverSlide 16Nominal Versus Real Interest Rates, and Present ValuesSlide 18Interest Rates and InvestmentNominal and Real Interest Rates, and the IS-LM ModelSlide 21Slide 22Money Growth, Inflation, and Nominal and Real Interest RatesRevisiting the IS-LM ModelNominal and Real Interest Rates in the Short RunNominal and Real Interest Rates in the Medium RunSlide 27Slide 28From the Short Run to the Medium RunSlide 30Slide 31Slide 32Slide 33Evidence on the Fisher HypothesisSlide 35Slide 361414C H A P T E RC H A P T E RPrepared by:Fernando Quijano and Yvonn QuijanoAnd Modified by Gabriel MartinezExpectations:Expectations:The Basic ToolsThe Basic Tools© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier BlanchardNominal Versus RealNominal Versus RealInterest RatesInterest Rates14-1Nominal interestNominal interest ratesrates are interest rates are interest rates expressed in terms of expressed in terms of dollars.dollars.Real interest ratesReal interest rates are are interest rates expressed in interest rates expressed in terms of a basket of terms of a basket of goods.goods.© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier BlanchardNominal Versus RealNominal Versus RealInterest RatesInterest RatesDefinition and Definition and Derivation of the Real Derivation of the Real Interest RateInterest Rateiitt = nominal interest rate for year = nominal interest rate for year tt..rrtt = real interest rate for year = real interest rate for year tt..(1+ (1+ iitt): Lending one dollar this ): Lending one dollar this year yields (1+ year yields (1+ iitt) dollars next ) dollars next year. Alternatively, borrowing one year. Alternatively, borrowing one dollar this year implies paying dollar this year implies paying back (1+ back (1+ iitt) dollars next year.) dollars next year.PPtt = price this year. = price this year.PPeet+1t+1= expected price next year.= expected price next year.Derivation© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier BlanchardNominal Versus RealNominal Versus RealInterest RatesInterest RatesConsequently, , which is the exact relation Consequently, , which is the exact relation between nominal interest rates, real interest rates, and between nominal interest rates, real interest rates, and inflation.inflation.1 11  r iPPt ttet( )etetttP PP1( )111 rittetWe knowWe knowNow,Now,PPtetet111( )© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier BlanchardNominal Versus RealNominal Versus RealInterest RatesInterest RatesIf the nominal interest rate and the expected rate of If the nominal interest rate and the expected rate of inflation are not too large, a simpler expression is:inflation are not too large, a simpler expression is:r it tet The real interest rate is (approximately) equal to the The real interest rate is (approximately) equal to the nominal interest rate minus the expected rate of inflation.nominal interest rate minus the expected rate of inflation.Notice that higher rates of expected inflation reduce the Notice that higher rates of expected inflation reduce the real interest rate, given the nominal interest rate.real interest rate, given the nominal interest rate.© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier BlanchardNominal and Real Interest Rates Nominal and Real Interest Rates in the United States Since 1978in the United States Since 1978Nominal and Real Nominal and Real One-Year T-bill One-Year T-bill Rates in the United Rates in the United States, 1978-2001States, 1978-2001While the nominal interest rate has declined considerably since the early 1980s, the real interest rate is actually higher in 2001 than it was then.Despite the large decline in nominal interest rates, Despite the large decline in nominal interest rates, borrowing is actually more expensive in 2001 than it borrowing is actually more expensive in 2001 than it was in 1981.was in 1981.Nominal© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier BlanchardNominal Versus RealNominal Versus RealInterest RatesInterest RatesExpected and actual inflation may differ.Expected and actual inflation may differ.r = i – r = i –  is called the is called the ex-postex-post real interest real interest rate.rate.r = i – r = i – ee is called the is called the ex-anteex-ante real interest real interest rate.rate.© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier BlanchardExpected PresentExpected PresentDiscounted ValuesDiscounted ValuesComputing Present Computing Present Discounted ValuesDiscounted Values14-2The expected present discounted value of a The expected present discounted value of a sequence of future payments is sequence of future payments is today’s today’s value value of this expected sequence of of this expected sequence of payments.payments.The term 1/(1+The term 1/(1+iitt) is called the ) is called the discount discount factorfactor, and the one-year nominal interest , and the one-year nominal interest rate, rate, iitt, it is often called the , it is often called the discount ratediscount rate..© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier BlanchardComputing Expected Present Computing Expected Present Discounted ValuesDiscounted Values(a) One dollar this year is worth (a) One dollar this year is worth 1+1+iitt dollars next year. dollars next year.(b) If you lend 1/(1+i(b) If you lend 1/(1+itt) dollars this ) dollars this year, you will receiveyear, you will receivedollar next year.dollar next year.111 1(( ) iitt© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier BlanchardComputing Expected Present Computing Expected Present Discounted ValuesDiscounted Values(c) One dollar is worth(c) One dollar is worth dollars two years from dollars two years from now.now.( ) ( )1 11 i it t(d) The present discounted (d)