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Unformatted text preview: Real and Nominal Interest Rates Pamela Labadie Fall 2010 Let’s start with some notation. Denote i t = nominal interest rate at time t r e t +1 = expected real interest rate at time t + 1 r t +1 = real interest at time t + 1 π e t +1 = expected inflation rate between periods t and t + 1 π t +1 = actual inflation rate Inflation π t +1 is computed as follows: π t +1 = bracketleftBigg p t +1 p t p t bracketrightBigg . We make two key assumptions: 1. Borrowers and lenders base their decisions on the real rate of interest, which measures the opportunity cost. 2. Expectations are rational. If the real rate of interest is unknown at the time the decision is made, a forecast is formed and, on average, this forecast is correct. Suppose you decide to purchase a government bond, so you are a saver. The nominal interest rate is i t at time t . The nominal interest includes both the real interest rate and the inflation rate. The real rate of interest is determined as r t +1 ≡ i t π t +1 .....
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 Fall '10
 LABADIE
 Interest Rates, Interest, Interest Rate, Nominal Interest Rate, real rate

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