Figure 11.2 The Ex Post Real Interest Rate Subtracting actual inflation from the nominal interest rate yields the ex post real interest rate. In the mid-1970s, inflation exceeded the nominal interest rate, so the ex post real interest rate was negative, due probably to the unexpected nature of the inflation. In the 1980s the nominal interest rate was quite a bit higher than inflation, making the ex post real interest rate very high, perhaps due to very high expectations of inflation, or to the high real interest rate policies of the time. Source: Economic Report of the President, 1999. www.access.gpo.gov/eop/
the firm's decision. The firm's future costs should rise by 7 percent, but so also should its receipts, so that its profits should grow, in nominal terms, by 7 percent. This growth provides just enough extra return to pay for the extra 7 percent interest costs. The relevant interest rate is thus the real rate of interest, not the nominal rate of interest.
This example suggests that firms should use the real rate of interest to evaluate investment projects, and economists should use the real rate of interest to analyze the influence of the interest rate on aggregate demand in the economy. Chapter 10 assumed zero inflation and so was analyzing the role of the real interest rate. What role does the nominal interest rate play?
11.3 The Nominal Rate of Interest
It would be a mistake to conclude from the preceding discussion that the nominal interest rate is unimportant either to individuals or to government. It is the nominal rate that makes headlines in newspapers, determines homeowners' monthly mortgage payments, and influ-
