Unit 4: Nominal v. Real Interest Rates

What is the Fisher Effect?

the relationship between nominal returns, real returns, and inflation (inflation + real interest rate = nominal interest rate)

What do lenders and borrowers establish? (rn)

they establish nominal interest rates as the sum of their expected real interest rate and expected inflation

What happens when expected inflation turns out not to be realized, and there is unexpected inflation?

- real rate of return decreases - real value of financial asset decreased inflation leads to the value of your financial assets being less than if you had calculated expected rates accurately

What is real interest rate?

- real rate of return earned on financial assets or paid back on loans - adjusted for inflation

What is nominal interest rate?

- the rate of interest paid for a loan, unadjusted for inflation - rate you see when doing business with a financial institution

How can real interest rate be calculated?

A real interest rate can be calculated in hindsight by subtracting the actual inflation rate from the nominal interest rate

when is actual inflation calculated?

Actual inflation is calculated after the term of the loan is over - There may be differences if we expect one thing and then realize what happens after

What does expected inflation help with?

expected inflation is what banks use to set a nominal interest rate - terms of a loan - savings vehicles (savings accounts, money market account, certificates of deposit) - expect inflation to occur and try to set interest rates on that expectation

What happens to real rate of return on fixed rate savings/loans when there is a higher unexpected inflation?

makes the real rate of return on fixed rate savings/loans lower

When is the real rate affected?

real rate affected if actually different from expected

Fisher Effect: what are the equations that helps us calculate the real rate of return?

rn= rr + inflation rr= rn - inflation - use on investments, financial assets, loans

How do lenders, borrowers, and savers make decisions about loaning, borrowing, or saving?

they make their decisions off of what they expect or anticipate inflation to be over the term their loan or saving (at the outset of the decision making)