MacroeconomicsI_working_version (1)

Inflation 95
Our real income will rise in case that nominal income increases faster than the price level.
A faster rise in the price level than in our nominal income will imply a decline in real
income. These relationships could be approximately expressed by the following formula:
Percentage
change in
real income
Percentage
=
change in
nominal
–
income
Percentage
change in
price level
9.5. Nominal vs. Real Interest Rate
Economists distinguish between the nominal interest rate and the real interest rate. The
problem of this distinction emerges because of the volatile price level inducing times of
inflation or deflation. Nominal interest rate represents a rate that investors pay to borrow
money. If we correct the nominal interest rate for effect of inflation (or deflation) we get
real interest rate.
9.5.1. Inflation and the Fisher Principle 3
The rate of inflation independently influences money demand. An unexpected increase in
the price level raises nominal money demand proportionately. In contrast, continuous price
increases – inflation – reduce the purchasing power of money. For example, with a 10%
annual inflation rate, a given stock of money in real terms is worth 10% less then a year
later.
The effect can be understood by the distinction between nominal and real interest rates. By
definition, the real interest rate (r) is the difference between the nominal interest rate (i) and
the expected rate of inflation (π e ):
r = i - π e
real interest
rate
nominal
interest rate
expected
inflation
For decision such as consumption and investment, we have seen that the interest rate is the
one that matters. In principle, no one would lend money at a nominal interest rate lower
than expected inflation because the interest payment does not compensate for the loss of
purchasing power. Implicitly, at least, borrowers and lenders agree that a positive real
interest rate should remunerate the lender. Over long periods, real interest rate should
remunerate the lender. Over long periods, real interest rate shows no trend. The nominal
rate can therefore be seen as the sum of the reward to the lender, or the cost of borrowing
(the real interest rate), and expected inflation. This is just rewritten as:
3 See Burda – Wyplosz [4]
i = r + π e