lecture13 - Economics 310 Money and Banking Lecture13...

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Economics 310 Money and Banking Lecture 13 University of Michigan  Fall 2010
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2 Lecture 1 Reading Bond Market and Interest Rates Chapters 4 and 5 Assignment available on line later today
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3 Lecture 1 Adjusting for expected inflation Let e be the expected inflation rate i be the nominal interest rate r be the real interest rate The real interest rate is The nominal interest rate Discounted by the expected inflation rate (1+r) = (1+i)/(1+ e )
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4 Lecture 1 Why  expected  inflation? We care about the real interest rate as it motivates the choices of agents When making decisions, agents are forward looking Factor into their decisions expectations about future price changes
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5 Lecture 1 The Fisher Equation Given: (1+r) = (1+i)/(1+ ∏ e ) Or: (1+r)(1+ ∏ e ) = (1+i) So that i = 1 + r + ∏ e + r. ∏ e -1 = r + ∏ e + r. ∏ e As r and ∏ e are typically small, we can ignore r. ∏ e So approximately i = r + ∏ e (Fisher Equation)
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6 Lecture 1 Real Interest Rate As an indicator of economic activity, we would like to know the real interest rate We know the nominal interest rate We don’t get to observe the expected inflation rate Where do we get real interest rate data? Use observed (ex post) inflation measure as a proxy for the expected inflation rate Use surveys Make use of TIPS
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7 Lecture 1 TIPS Treasury Inflation Protected Securities i.e. Indexed bonds Promises a series of payments in real terms
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