Well we have to account for the fact that stuff's going to be more expensive. So we have to
account for inflation in doing this. And the way we do this is by recognizing that what we've
done so far is we've talked about the nominal interest rate. By the nominal interest rate, I
meant the interest rate that you actually see posted in the bank.
But what matters, ultimately for your well-being, is the real interest rate which is what your
money can do in terms of actually buying goods. So I should not care about how much money
I have next year. I should care about how many goods I can buy next year. The money's just
paper. What matters is what I can get with it. That's what matters.
So let's say, for example, I want to use all my money on Skittles. That's just what I want to use
my money on. So let's say I have $100, and I want to spend that money on Skittles. And let's
say Skittles today are $1 a bag. And let's say the interest rate, once again, is 10%. And let's
say there's no inflation. Inflation equals zero. So my choice is I can spend $100 on Skittles
today and get 100 bags. So I could have 100 bags today. Or I can save it, have $110
tomorrow and get 110 bags of Skittles. That's my choice. That's my trade-off.
Now let's say there's inflation. Let's say that prices are rising at 10% a year, as well. So the
prices are rising 10% a year, as well. What that means is next year Skittles cost $1.10 a bag.
So now what's my trade-off? That means I could have 100 bags today or 100 bags tomorrow.
I don't get any more Skittles tomorrow. I get 10 more dollars, but who cares? Everything costs
more. If everything cost 10% more and I get a 10% interest rate, that interest rate is effectively
zero in terms of what I can buy.
The real interest rate is the nominal interest rate minus inflation. What I care about is what I
can buy. So I have to take out of the interest rate what happens to prices. Because if prices go
up, it offsets what I'm earning in the bank. And so what I care about is I care about what the
bank posts minus what inflation will be. So it's even trickier, right? Because it's not about what
inflation was, it's what inflation will be. You'll have to guess what inflation is going to be.
And so what we care about is this real interest rate. And that's why the interest rate that banks
pay, a primary determinant of it is inflation. Right now, we are in the lowest inflation period this

nation's seen since World War II. Core inflation-- we don't really get into inflation in this course-
- but core inflation, which is inflation minus some things which fluctuate a lot, is basically zero
in the US. So, basically, nominal interest rates are the same as real interest rates, and that's
why the interest rates you see posted are so incredibly low because there's no inflation.

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- Summer '17
- Inflation