Curiosity 9.3: Should the Fed Be Independent?

		11 Real Versus Nominal Interest Rates

		Up to this point, our analysis of interest rates has been in the context of a noninflationary economy. The interest rate that we read about in the paper, pay on our mortgages, and earn on our bank deposits, however, contains a premium for expected inflation. Consequently, a major determinant of this interest rate is the expected rate of inflation, which in an inflationary economy usually swamps the effects of the factors discussed in the preceding chapter. Forecasting interest rates in an inflationary economy hinges on forecasting inflation. All other forces affecting interest rates are of secondary importance.

		Economists draw a distinction between the interest rate with and without this premium for expected inflation; the former is called the nominal interest rate, and the latter the real interest rate. The most common error students make when analyzing the interest rate is to overlook the difference between the real and nominal interest rates. The purpose of this chapter is to spell out this difference and explain its importance in a variety of contexts.