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

The Committee perceives the upside and downside risks to the attainment of both
sustainable growth and price stability for the next few quarters are roughly equal.
With underlying inflation still expected to be relatively low, the Committee believes
that policy accommodation can be removed at a pace that is likely to be measured.
Nonetheless, the Committee will respond to changes in economic prospects as needed
to fulfill its obligation to maintain price stability.
REAL INTEREST RATES AND NOMINAL
INTEREST RATES
To understand the links between the Fed’s decisions and real output and inflation,
we must start by recalling an important distinction between real interest rates and
nominal interest rates. The nominal, or market, interest rate gives the percentage
rate of return on a deposit, loan, or financial asset without taking into account the
effects of inflation. When prices are rising, the value of a dollar is falling since each dollar
will buy fewer and fewer goods and services over time. The dollars a borrower repays
are worth less than the dollars that were borrowed. When prices are falling, the
value of a dollar is rising since each dollar will buy more and more goods and services
over time. The dollars a borrower repays are then worth more than the dollars
that were borrowed. The nominal interest rate as a measure of the cost of a loan or
the rate of return on a financial asset fails to correct for these changes in the value
of money.
The real rate of interest is the percentage return on a deposit, loan, or other
financial asset after the effects of inflation are taken into account. It represents the
change in the real purchasing power that the lender receives. If the market rate of
interest is 6 percent and inflation is 2 percent, the real interest rate is 4 percent;
2 percentage points of the 6 percent nominal interest rate represent compensation
for the falling value of the dollar. The relationship between the real rate of interest,
the nominal rate of interest, and inflation 3 is given by
New York Stock Exchange traders listen
to the results of a recent FOMC meeting.
nominal rate of interest = real rate of interest + inflation.
Figure 33.5 shows the nominal federal funds rate, the inflation rate, and the nominal
funds rate minus the inflation rate as a measure of the real interest rate. Two
points are worth noting. First, the level of nominal and real interest rates can differ
significantly. In the 1970s, for instance, the nominal funds rate was high, yet the real
rate was negative for most of the decade. In the 1990s, the nominal funds rate was
lower than it had been in the 1970s, yet the real rate was higher. Second, the average
level of the funds rate moves closely with inflation. Periods of high inflation typically
are associated with a high nominal interest rate; periods of low inflation typically
are associated with a low nominal rate.
Given the definition of the nominal interest rate, it is easy to understand why
nominal interest rates are high when inflation is high. Both borrowers and lenders
3 We are ignoring taxes on interest income here.
MONETARY POLICY ∂ 739