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 $1,000,000Nominal 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