Financial Markets and Institutions (2-downloads)

there are greater incentives to borrow and fewer incentives to lend.

The distinction between real and nominal interest rates is important because the

real interest rate, which reflects the real cost of borrowing, is likely to be a better indi-

cator of the incentives to borrow and lend. It appears to be a better guide to how peo-

ple will be affected by what is happening in credit markets. Figure 3.1, which presents

estimates from 1953 to 2010 of the real and nominal interest rates on three-month

U.S. Treasury bills, shows us that nominal and real rates often do not move together.

able to buy 2% fewer goods at the end of the year, and you will be 2% worse off in

real terms.

where

i

=

nominal interest rate

= 0.08

e

=

expected inflation rate

= 0.10

Thus,

i

r

⫽ 0.08 ⫺ 0.10 ⫽ ⫺0.02 ⫽ ⫺2%

p

i

r

⫽ i ⫺ p

e

16

12

8

4

0

–4

1955

1960

1970

1990

2000

Interest

Rate (%)

2005

2010

1980

1965

1975

1995

1985