Nominal vs. Real Interest Rates and Economic Variables

Correcting Economic Variables

• Dollar figures from different times need adjustment to reflect their real value.
• The formula to convert dollar amounts from year T to today's dollars is:
  Amount in today's dollars = Amount in year T dollars \times \frac{Price level today}{Price level in year T}
• Example:
  • If the Tooth Fairy left 0.10 in 1955, we want to find its real value today.
  • CPI in 1955 was 26.8.
  • CPI today is 219.
  • Real Value = (0.10) \times \frac{219}{26.8} = $0.82

Real and Nominal Interest Rates

• Nominal interest rate
  • The interest rate as usually reported.
  • It does not account for the effects of inflation.
• Real interest rate
  • The interest rate corrected for the effects of inflation.
  • Calculated as:
    Real\ interest\ rate = Nominal\ interest\ rate - Inflation\ rate$$

Figure 3: Real and Nominal Interest Rates

• This figure uses annual data since 1965 to show nominal and real interest rates.
• The nominal interest rate is the rate on a 3-month Treasury bill.
• The real interest rate is the nominal interest rate minus the inflation rate, as measured by the Consumer Price Index (CPI).
• Nominal and real interest rates often do not move together.

Interest Rates in the U.S. Economy

• The U.S. economy has generally experienced rising consumer prices every year.
• This means the nominal interest rate typically exceeds the real interest rate.
• In periods of deflation (falling prices):
  • The real interest rate would exceed the nominal interest rate.