[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

past twenty years computer prices have fallen while housing prices in many parts of
the country have risen very rapidly. The inflation rate measures what is happening
on average to prices in the economy.
Individuals want to know how much consumption they get tomorrow if they give
up a dollar’s worth of consumption today. The answer is given by the real rate of
interest. This is distinguished from the nominal rate of interest, the rate posted
at banks and printed in newspapers, which simply describes the number of dollars
received next year in exchange for a dollar today. There is a simple relationship
between the real interest rate and the nominal interest rate: the real interest rate
equals the nominal interest rate minus the rate of inflation. If the nominal interest
rate is 10 percent and the rate of inflation is 6 percent, then the real interest rate is
4 percent. By saving a dollar today, you can increase the amount of goods that you
get in one year’s time by 4 percent.
Consider an individual who decides to deposit $1,000 in a savings account. At
the end of the year, at a 10 percent interest rate, she will have $1,100. But prices
meanwhile have risen by 6 percent. A good that cost $1,000 in the beginning of the
year now costs $1,060. In terms of “purchasing power,” she has only $40 extra to
spend ($1,100 − $1,060)—4 percent more than she had at the beginning of the year.
Wrap-Up
REAL INTEREST RATE
Real interest rate = nominal interest rate − rate of inflation.
Using the Model: Saving and the Interest Rate We can use the budget
constraint to understand how Joan’s saving decision will be affected if the interest
rate changes. Keep in mind two points as we apply this model, however. First, just
as we saw earlier that the relevant wage for labor supply decisions is the real wage,
so the relevant interest rate for saving decisions is the real interest rate—that is,
the interest rate adjusted for inflation. Also keep in mind that we have simplified
the saving decision with our two-period model (current consumption on the one
hand, future consumption on the other). In the real world, individuals usually earn
interest on their savings year after year as they save for retirement. If you begin
saving at the age of twenty-five, you might earn interest for forty years before retiring.
Typically, the interest is compounded annually (or monthly), which means that
each year you earn interest on the interest paid in previous years. Compounding
makes a huge difference over long periods of time. If you set aside $100 at 5 percent
interest for forty years, you might think that each year you would earn $5 in interest
(5 percent of $100) and that at the end of the forty years you would have your
$100 plus $200 in interest (40 × $5), or $300 in total. In fact, because you earn interest
for thirty-nine years on the $5 of interest earned in year one, plus interest for
thirty-eight years on the interest earned in year two, and so on, after forty years you
end up with not $300 but $704!
SUPPLY IN THE CAPITAL MARKET ∂ 195