understand the difference between nominal and real interest rates;
realize that monetary policy is much more complicated than the previous chapter would have us believe; and
recognize that anything affecting the expected rate of inflation, such as money-supply growth, influences the bond market through its impact on the nominal interest rate.
11.1 Expected Inflation
Suppose that the interest rate is 5 percent and that suddenly everyone expects prices to rise by 3 percent (instead of 0 percent) during the next year. Those loaning money for a year at 5 percent will expect to receive, at the end of the year, dollars worth 3 percent less in terms of their purchasing power, so their expected net return in real terms is only 2 percent. To obtain a return of 5 percent, they will want to charge 8 percent. Those willing to borrow earlier at 5 percent should now be willing to pay 8 percent because they expect to be able to save 3 percent by buying their car (for example) now rather than next year, and because they expect to pay back their loans with devalued dollars. Consequently, the interest rate increases by 3 percent, the expected rate of inflation.
This example reflects a fundamental economic result: built into the interest rate is a premium for expected inflation. Lenders require this premium to prevent inflation from eroding the real value of their wealth, and borrowers pay this premium to be able to buy now before prices go up. We thus expect the interest rate to be affected by the expected rate of inflation, as illustrated in figure 11.1. Economists have captured this phenomenon by distinguishing between the real and the nominal interest rates.
The nominal interest rate includes the inflation premium; it is the interest rate observed on the markets, discussed in the media, paid on mortgages, and earned on savings accounts. The real interest rate is the nominal rate less the expected rate of inflation:
Real rate = Nominal rate - Expected inflation rate
11.2 The Real Rate of Interest
Because the expected rate of inflation is not known, the real rate of interest cannot be measured directly. Nevertheless, measurements of it appear in the media. Such measurements have two possible origins:
