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PSU ECON 104 - Real and Nominal Interest Rate

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Econ 104 1st Edition Lecture 12 Outline of Last Lecture I. Calculating inflation rateII. Purchasing powerIII. Consequences of inflation IV. Real vs Nominal IncomeV. Inflation interest ratesOutline of Current Lecture I. Interest RateII. Unanticipated Inflation III. Business Cycle Current LectureI. The interest rate is the a. Cost of borrowing and the return to lending II. Real vs Nominala. Nominal: interest rate (i) the stated interest rate on a loan, saving account, certicifate of deposit (CD)i. Is observableb. Real interest Ratei. Is not obersavable c. Expected interest rate: (i) = r + expected inflation III. Unanticipated inflation: is it better for the borrower or the savera. BorrowerIV. EXAMPLE: Suppose in 2015a. Expected inflation is 0%b. Unanticipated inflation is 10% (actual expected)c. Lenders and savers losei. You inherit $10,000 at the end of 20151. You place in savings account at PNC for 1 year at 5% = u These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.a. At the end of 2015:i. 10,000X1.05 = $10,5002. Case 1: Inflation = 0% in 2015a. A the end of year you owe $10,000 X 1.05 = $10,5003. Case 2: Inflation = 10% in 2015a. Real Value of loan at the end of 2015i. (10,500)/(110/100) = $9545b. Purchasing power has declinedd. Borrrowers:i. Exampleii. PNC gives you a loan for $10000 at 5% interest = u 1. Case 1: Inflation = 0% in 2015a. A the end of year you owe $10,000 X 1.05 = $10,5002. Case 2: Inflation = 10% in 2015a. Real Value of loan at the end of 2015i. (10,500)/(110/100) = $9545V. Summary: a. Interest rate shrinks income: as interest rises, real income fallsi. Inflation hurts when it is unexpected b. Base year CPI is always 100c. Nominal interest rates can never be negatived. Real interest rates can be positive or negativei. Negative when inflation is risinge. When r<0 lenders and savers both losei. Interest earnings do not keep up with inflation f. When r<0 borrowers win!i. They pay back less than real terms g. Concludei. r<0 1. You are more likely to spend ii. r>01. You are more likely to saveVI. Business Cyclea. Alternating periods of economic growth and contraction, which can be measuredin changes in real GDPb. Has four cycles i. Expansion1. Production, employment, and income are increasing Spending by firms and households increases. ii. Peak1. the expansion endsiii. Recession1. Production, employment, and income are decreasing. Spending byfirms and households decreases.iv. Trough1. The recession endsc. One Cycle: Peak to


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PSU ECON 104 - Real and Nominal Interest Rate

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