Chapter4

# Chapter4 - Chapter 4 Inflation and Interest Rates in the...

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© Sanjay K. Chugh 53 Spring 2008 Chapter 4 Inflation and Interest Rates in the Consumption-Savings Model The lifetime budget constraint (LBC) from the two-period consumption-savings model is a useful vehicle for introducing and analyzing the important macroeconomic relationship between inflation, nominal interest rates, and real interest rates. Before doing so, we present definitions of these terms and a basic relationship among them. The Fisher Equation Inflation is a general rise in an economy’s price level over time. Formally, an economy’s rate of inflation is defined as the percentage increase in the price level from one period of time to another period of time. In any period t , the inflation rate relative to period 1 t ± is defined as 1 1 , tt t t PP P S ± ± ± where denotes the inflation rate. 30 As a matter of terminology, a deflation (negative inflation) occurs when S < 0, and a disinflation occurs when S decreases over time (but is still positive at every point in time). For example, if in four consecutive years, inflation was 20%, 15%, 10%, and 5%, we say that disinflation is occurring – even though the price level increased in each of the four years. In our consideration of the consumption-savings model, we defined the nominal interest rate as the return on each dollar kept in a bank account from one period to the next. For example, if your savings account (in which you keep dollars) pays you \$3 per year for every \$100 you have on balance, the nominal interest rate on your savings account is three percent. Because of inflation, however, a dollar right now is not the same thing as a dollar one year from now because a dollar one year from now will buy you less (generally) than a dollar right now. That is, the purchasing power of a dollar changes over time due to inflation. Because it is goods (i.e., consumption) that individuals ultimately care about and not the dollars in their pockets or bank accounts, it is extremely useful to define another kind of interest rate, the real interest rate. A real interest rate is a return that is measured in terms of goods rather than in terms of dollars. Understanding the difference between a nominal interest rate and a real interest rate is important. An example will help illustrate the issue. 30 Not to be confused with profits, which is what ʌ typically represents in microeconomics. The usage is almost always clear from the context.

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© Sanjay K. Chugh 54 Spring 2008 Example: Consider an economy in which there is only one good – macroeconomics textbooks, say. In the year 2000, the price of a textbook is \$100. Wishing to purchase 5 textbooks (because macroeconomics texts are so much fun to read), but having no money with which to buy them, you borrow \$500 from a bank. The terms of the loan contract are that you must pay back the principal plus 10% interest in one year – in other words, you must pay back \$550 in one year. After one year has passed, you repay the bank \$550. If there has been zero inflation during the intervening one year, then the purchasing power of that \$550 is 5.5 textbooks, because the price of one textbook is still \$100.
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Chapter4 - Chapter 4 Inflation and Interest Rates in the...

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