Appendix 11.1 Eight Applications of Real Versus Nominal Interest Rates
Because it is a key ingredient in explaining such a wide variety of media commentary, the distinction between real and nominal interest rates is the most important macroeconomic concept introduced in this book. There are eight general types of applications to note.
1. Definitional interpretation. Some applications merely require knowledge of the difference between real and nominal interest rates and the fact that it is the real interest rate that affects spending:
Moreover, contrary to the central bank's pronouncements, higher interest rates have not caused everyone to borrow less. Most people are borrowing as much as ever or more to buy goods now.
In this case, the higher interest rate must be a higher nominal interest rate but a lower real interest rate because of high inflation expectations.
2. Forecasting interest rates. Substantive changes in the nominal interest rate are usually due more to changes in expected inflation than to changes in the real interest rate:
Corporate treasurers should not be frightened by the recent rise in interest rates on bonds. Rates of even 13 percent will look like bargains if inflation heats up over the next 18 months.
A corporate treasurer deciding when is the best time to issue his or her corporation's bonds must pay close attention to inflation expectations.
3. The interest rate as a monetary policy indicator. Equating high interest rates with tight monetary policy is a recipe for disaster in an inflationary environment. The high interest rate could be a high nominal rate but a low real rate, and so be a misleading guide to the true stance of monetary policy. An example is the following, discussed earlier as example 4 in the media illustrations section of this chapter.
Although interest rates were for many years the main policy indicator used by most central banks, the experience with severe inflation beginning in the 1970s made it clear they were fickle guides for the task of ensuring that monetary policy was directed toward price stability.
4. The influence of expected inflation on the bond market. Millions of dollars are made and lost on the bond market daily, due to fluctuating nominal interest rates:
A smaller-than-expected decrease in the U.S. money supply dealt the North American capital market a hard blow, as bond prices sagged across a broad front.
This is a typical news report emphasizing that inflation expectations are strongly influenced by money growth figures. In this case, because the decrease was smaller than expected, inflation expectations were revised upward, raising the nominal interest rate and lowering bond prices.
5. How economic news affects the bond market. An apparent oddity in the real word is the fact that bad economic news (higher unemployment, for example) is interpreted as good news for bond markets, causing the bond market to surge, and good economic news
