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!

Nominal Interest Rate = Real Interest Rate + Expected Inflation Reworking above formula: Real = Nominal – Expected Inflation If expected inflation = 2.0%: The real interest rate is 0.5% (2.5% - 2%) Purchasing Power ↑ $5,000 per year 10-year Gov’t Bond Purchase $1,000,000 Nominal Interest Rate 2.50% Nominal dollars per year: $25,000 (interest per year) In 10-years:$1,000,000 principal paid back Adjusting Interest Rates for Inflation

Practice Test #3