expectations: the basic tools chapter 14. © 2013 pearson education, inc. all rights reserved.14-2...

Expectations:The Basic Tools

Chapter 14

© 2013 Pearson Education, Inc. All rights reserved. 14-2

14-1 Nominal versus Real Interest Rates

Figure 14-1 Definition and Derivation of the Real Interest Rate



Figure 14-2 Nominal and Real One-Year T-Bill Rates in the United States since 1978


Focus: Why Deflation Can Be Very Bad: Deflation and the Real Interest Rate During the Great Depression

Table 1 The Nominal Interest Rate, Inflation, and the Real Interest Rate, 1929–1933


14-2 Nominal and Real Interest Rates, and the IS–LM Model


14-3 Money Growth, Inflation, Nominal and Real Interest Rates

Figure 14-3 Equilibrium Output and Interest Rates



Figure 14-4 The Short-Run Effects of an Increase in Money Growth


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14-3 Money Growth, Inflation, and Nominaland Real Interest Rates

Nominal and Real Interest Rates in the Medium Run

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In the medium run, the rate of inflation is equal to the rate of money growth minus the rate of growth of output.

In the medium run, output returns to the natural level of output,

At the ``natural’’ level of unemployment,

So that, in the medium-run,


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•In the medium run, the nominal interest rate increases one for one with inflation. This result is known as the Fisher effect, or the Fisher Hypothesis.

For example, an increase in nominal money growth of 10% is eventually reflected by a 10% increase in the rate of inflation, a 10% increase in the nominal interest rate, and no change in the real interest rate.

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Nominal and Real Interest Rates in the Medium Run


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•In the short run, lower nominal interest rates lead to higher output and inflation. In the medium run, this situation changes.

•In the short run,

•Over time,•In the medium run,

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E ven tua lly g g im m' ( ' ) 0

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Y Ynu u n g m

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From the Short Run to the Medium Run


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•In words:

– So long as the real interest rate is below the natural real interest rate, output is higher than the natural level of output, and unemployment is below its natural rate.

– From the Phillips curve relation, we know that as long as unemployment is below the natural rate of unemployment, inflation increases.

– As inflation increases, it becomes higher than nominal money growth, leading to negative real money growth.

– In the medium run, the real interest rate increases back to it initial value.


From the Short Run to the Medium Run



Figure 14-5 The Adjustment of the Real and the Nominal Interest Rates to an Increase in Money Growth


Focus: Nominal Interest Rates and Inflation across Latin America in the Early 1990s

Figure 1 Nominal Interest Rates and Inflation: Latin America, 1992–1993



Figure 14-6 The Treasury Bill Rate and Inflation in the United States since 1927


14-4 Expected Present Discounted Values

Figure 14-7 Computing Present Discounted Values


14-4 Expected Present Discounted Values


Appendix: Deriving the Expected Present Discounted Value Using Real or Nominal Interest Rates

expectations: the basic tools chapter 14. © 2013 pearson education, inc. all rights reserved.14-2...

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