THE SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM AND THE ECONOMY (part 15)

Inflation and Interest Rates

by

Charles Lamson

If you lend a friend $100 today and she agrees to pay it back in one year with 5 percent interest ($100 X .05 = $5), you may consider yourself $5 richer and a shrewd financier. Your $100 will earn $5 of income for you. However, if during the year the inflation rate is 5 percent, the real value---purchasing power---of the funds lent plus interest will be exactly the same as the real value of your funds at the beginning of the year. As a result, your real reward for lending would be zero. In fact, if the inflation rate is greater than 5 percent, your friend would be paying you back an amount of money one year from now that would buy fewer goods than the amount you lent would buy today. Your real reward would be negative. The shrewd financier in this case would be your friend, not you! You might, of course, still engage in this transaction if it is your absolute best opportunity. If you hold idle cash or money in a checking account earning low interest, you would lose even more in real terms. However, we hope you would lose even more in real terms. However, we hope you would be able to find a saving opportunity that paid you a positive real return.

This example suggests that lenders are concerned about two things: (1) nominal interest, or how many dollars will be received in the future in return for lending now; and (2) inflation, or the real purchasing power the funds will be worth upon repayment. For example, a bond bearing even a relatively high interest rate may not be attractive to lenders if, due to price inflation, the money later repaid has less purchasing power than the money originally lent.

The implication of all this is that the market interest rate---called the nominal interest rate---is not an adequate measure of the real return on an interest-bearing financial asset unless there is assurance of price stability. Rather, the appropriate measure is the real interest rate, which is the return on the asset corrected for changes in the purchasing power of money. The real interest rate is the nominal interest rate minus the rate of inflation expected to prevail over the life of the asset. For example, if an investor expects inflation of 4 percent, then an asset bearing 7 percent nominal interest will be expected to yield only approximately only 3 percent in real terms. If inflation of 7 percent is expected, the investor would expect the asset bearing 7 percent nominal interest to yield nothing in real terms.

Money illusion is said to occur when investors react to nominal changes (caused by price changes), even though no changes in real interest rates or other real variables have occurred. Financial investors who are not victims of money illusion will try to find an investment that pays the highest real return. Wise investors will concern themselves with the nominal market interest rate only insofar as it enters into their calculation of the real interest, which is the correct measure of the reward for lending and the cost of borrowing.

The discussion to this point can be summarized with the help of some simple definitions. The nominal interest rate has two parts: a real interest rate and an inflation premium. The inflation premium is the amount of nominal interest that will compensate a lender for the expected loss of purchasing power accompanying any inflation. Accordingly, the inflation premium is equal to the expected inflation rate, and therefore, nominal interest rates rise or fall as expected inflation rises or falls, ceteris paribus.

In sum, expectations of inflation affect portfolio choices that help determine the demand and supply of loanable funds. Since interest rates respond to changes in supply and demand, and expectations of inflation affect demand and supply, we can conclude that expectations of inflation affect demand and supply. Also, we can conclude that expectations of inflation affect interest rates. 

Recap

The nominal interest rate is the real interest rate plus the expected inflation rate. Money illusion occurs when react to nominal changes when no real life changes have occurred. If expected inflation increases, the nominal interest rate will rise. Borrowers are then willing to pay an inflation premium, and lenders demand to be paid an inflation premium. Thus nominal interest rates are correlated with expected inflation.

*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, PGS. 140-142*

END