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1 Unemployment, Inflation, and Interest Rates As real GDP (Y) (spending by consumers (C) + businesses (J) + the government ( G) + foreigners ( X) ( net exports: exportsimports) changes over time, so do other economic variables, such as unemployment, inflation, and interest rates. These economic variables give us a better understanding of the human story behind the changes in real GDP and why real GDP changes over time. Page 1

2 Interest Rates The interest rate is the amount lenders charge when they lend money, expressed as a percentage of the amount loaned. For example, if you borrow $100 for a year from a friend and the interest rate on the loan is 6%, at the end of the year you must pay your friend back $6 in interest in addition to the $100 you borrowed. Not a nice friend!! The interest rate is another key economic variable that is related to the growth and change in real GDP (Y) of a country's economy over time. UNITED ST ATES INTERES T RA TE 6 Page 2 o ~--~ r----- Jar /JO Jnn 02 J n lo..- Jan GS Jan '10 Jan, 12 o V12tlr

3 Interest Rates (cont.) When interest rates are down, people borrow and spend more because it is cheaper to. When interest rates are up or rising, people spend less, which can lead to a recession and usually higher unemployment because less is purchased. This leads to companies laying off employees. Laid off, the former employees then spend less which leads to less purchases, and so on. An interest rate that does not change, such as a 5-year car loan at 2%, is referred to as a fixed interest rate, while those that can change are referred to as flexible interest rates. UNITED STATES I.NTEREST RATE B g ~, J ar /00 Jan '02 Jan / 0-4 Jan /Oil Jan / 08 Ja n/ 1 0 Jan 1 2

4 Interest Rates (cont.) The fluctuations in interest rates are intimately connected with the trends and fluctuations in inflation and real GDP (Y). When inflation rises, people who lend money will be paid back in the long-run (LR) with funds that are worth less because the average price of goods rises more quickly than inflation. To compensate for this decline in the value of funds, lenders require a higher interest rate just in case inflation rises during the loan. For example, if a bank lends someone $10,000 for a year at 6%, but inflation unexpectedly pushes the interest rate to 9%, then the bank is actually at -3% interest. The bank loses and the borrower gains because inflation was higher than expected; the borrower paid less for the loan. Interest rates influence people's economic behavior. When interest rates rise, it is more expensive to borrow money or to buy a house or a car, so many people postpone such purchases. Page 4

5 Macroeconomics Do-Now Please do this: 1. If a bank lends you $50,000 at 4 /o fixed interest for your college costs, but inflation moves the interest rate to 6.5 /o. Is the bank the winner or are you the winner? Explain. You are the winner because you got the loan for less than the current interest rate. :-) 2. If a bank lends you $2,000,000 at 9o/o fixed interest for surgery, but the change in the price level moves the interest rate to 7 /o. Is the bank the winner or are you the winner? Explain. You lose. :-( The bank is the winner because you got the loan for more than the current interest rate.

6 Interest Rates (cont.) Economists define the term nominal interest rate as the interest rate on a loan, making no adjustments for inflation ( a loan of 9%, including 5% inflation ). The real interest rate is the nominal interest rate minus the inflation rate (9% - 5% == 4% ). The real interest rate is adjusted for the growth rate of the economy. real interest rate= nominal interest rate - h. fl... d. fl. soa (inflation rate) t e In ation rate or anticipate In ation rate -~ 0 ( 9% (nominal interest rate) i nterest rate) 40; 0 rea 1 Fully anticipated increases in inflation lead to increased nominal rates, like when the government spends money during a recession to grow the economy. Deficit spending by a country also leads to an increase in the nominal interest rate. If nominal interest rates are low, people and businesses borrow and spend more. The chance of inflation and recession then grow. If rates are high, there is less chance of inflation or recession. -

7 The Interest Rate and Inflation The figure below represents the monetary policy rule graphically. The nominal interest rate must rise by more than the inflation rate if the real interest rate is to rise when inflation rises. I NTEIU ~~r RA1l-~ (P t-:lu' I:'\ f) ninal int r 'L rat H a1 in t r' t rat. { l (j 7 l ~E-1.. AT fo ' H "' E ( PJ:::H r:s1 ) Page 6

8 Interest Rates-Questions 36. In the long run, a fully anticipated increa e in the inflation rate will (A) increa e real national output (B) increase the nominal interest rate (C) decrea e real national output (D) decrea e the real int ere t rate (E) hift the long-run Phillip curve to the right Page A lender will realize unexpected benefit when the (A) actual inflation rate i higher than the anticipated inflation rate (B actual inflation rate i lower than the anticipated inflation rate (C) rate of intere tis greater than the actual rate of inflation (D) rate of intere tis le s than the actual rate of inflation (E) rate of intere t equal the actual rate of inflation

9 Interest Rates-Questions 36. In the long run, a fully anticipated increa e in the inflation rate will decrease (A) increttsa real national output (e ) increase the nominal interest rate (C) decrea e real national output but not definitely (D) decrea e the real intere t rate can't decrease it in inflation is increasing (E) hift the long -run Phillip curve to the right 59. A lender will realize unexpected benefit when the if the inflation rate is higher (A actual inflation rate i higher than the than expected then the rate d fl - people received when ant1c1pate in at1on rate borrowing will benefit them (e ) actual inflation rate i lower than the and not the lender anticipated inflation rate (C) rate of intere tis greater than the actual rate Page 78 of inflation (D rate of intere t is le s than the actual rate of inflation (E rate of intere t equals the actual rate of inflation we don't know what the anticipated inflation rate was 1 so we can't determine if the lender is benefiting or not

10 Interest Rates-Questions 59. The real intere t rate eruned i the Page 13 (A) aine as the nominal interest rate when inflation is moderate (B) cost of borrowing in current con sumer price s (C) cost of borrowing in current producer prices (D) cost of borrowing adju ted for the rate of change in the price level (E) nominal interest rate adju sted for the growth rate of the economy 60. When purcha ing her house, M. Jones took out a 15-year mortgage loan from a local bank at a fixed intere t rate of 7 percent. The rate of expected inflation at the time was 3 percent. If the actual rate of inflation was 4.5 percent, which of the following is true? (A) The bank gained because the real rate of intere t increa ed by 1.5%. (B) The bank gained because the real rate of intere t became 3.5o/o. (C) The bank lo t because the real rate of interest decreased by l.s o/o. (D) Ms. Jone gained becau e the nominal rate of intere t increa ed by 1.5%. (E) M. Jones lost because the nominal rate of intere t became 3.5%.

11 Interest Rates-Questions 59. The real intere t rate earned i the Page 80 (A) ame a the nominal interest rate when -but what is moderate; not specific enough inflation i moderate (B) cost of borrowing in current consumer prices yes, but "real" means adjusted, not nominal (C) cost of borrowing in current producer prices ~consumer prices. ) cost of borrowing ad ju ted for the rate of change in the price level (E) nominal interest rate ad justed for the growth.-- not specific enough, and D rate of the economy encompasses E 60. When purchasing her house M. Jones took out a 15-year mortgage loan from a local bank at a fixed intere t rate of 7 percent. The rate of expected inflation at the time was 3 percent. If the actual rate of inflation was 4.5 percent, which of the following is true? (A) The bank gained because the real rate of real rate decreased intere t increa sed by 1.5%. (B) The bank gained because the real rate of ~no, the real interest rate became 8.5 /o intere t became 3.5o/o. The bank lost because the real rate of interest decrea sed by 1.5%. (D) ~s. Jone. gained becau e the nominal rate >f can't be the nominal rate because the 1ntere t 1ncrea ed by 1.5%. adjustment for expected inflation (E) Ms. Jones lost because the nominal rate of took place intere t became 3.5%.

12 Unemployment, Inflation, Interest Rates, and real GDPtd.U How unemployment, inflation, and interest rates impact an economy's real GDP/AD *an j in aggregate demand (AD)/real GDP (f) the price level (PL)/inflation j aggregate supply (AS) j unemployment t the federal funds rate j the nominal then real interest rate to j interest-sensitive spending to t a t in aggregate demand (AD)/real GDP (f) *at in aggregate demand (AD)/real GDP (Y) the price level (PL)/inflation t aggregate supply (AS) t unemployment j the federal funds rate t the nominal then real interest rate to t interest-sensitive spending to j an j in aggregate demand (AD)/real GDP (f)

13 Different Types of Interest Rates and Their Behavior There are many different interest rates in the economy. The mortgage interest rate is the rate on loans to buy a house. The Treasury bill rate is the interest rate the government pays when it borrows money from people for a year or less. The federal funds rate is the short-term interest rate banks charge other banks on overnight loans; this rate can be adjusted up or down by actions taken by the Federal Reserve (the "Fed") to grow the economy and slow down inflation. To increase the money supply and grow the economy, the government buys bonds from banks to increase the amount of money banks can loan. Bonds (securities) are loans that people give out with their money to a company or government and they promise to pay you back in full, with regular interest payments. When the Fed buys or sell bonds it is called monetary policy, and it is critical in making an economy stable. When the Fed sets higher interest rates, the banks pass along the higher rates to borrowers, and vice versa when rates go down ~ocab. quiz next class

14 The Federal Funds Rate When inflation is high, the federal funds rate is low to grow the economy. When inflation is low, the federal funds rate increases to slow down the economy by slowing spending. - ) ~ i~~~~~ ~ l 8-6 Qi u..l,.,j~l.i.l,,..,l.l~l..11,...&.j~...,a..:u~..jr-:&,..1,~..a,.../l...l.j...l...l,...l.a...lu,...l...l..l,,j-1,...:,1...:&...ll,,j,...l.&...l...l,:lii ~...,_ :a..,..;, 195 1\ lj9 0 1:9~ : (), n

15 The Federal Funds Rate-Questions 48. Which of the following accurately de cribe the federal fund rate? A The intere t rate that bank charge tate government (B The intere t rate that bank charge other bank for overnight loan C The intere t rate that bank pay on long-term. av1no (D The intere t rate on per onal loan E The intere t rate on government bond

16 The Federal Funds Rate-Questions 48. Which of the following accurately de cribe the federal fund rate? A The intere t rate that bank charge tate government (9 The intere t rate that bank charge other direct definition bank for overnight loan C The intere t rate that bank pay on long-term. av1no (D The intere t rate on per onal loan E The intere t rate on government bond

17 Unemployment, Inflation, Interest Rates, and real GDPtd.U How unemployment, inflation, and interest rates impact an economy's real GDP/AD *an j in aggregate demand (AD)/real GDP (f) the price level (PL)/inflation j aggregate supply (AS) j unemployment t the federal funds rate j the nominal then real interest rate to j interest-sensitive spending to t a t in aggregate demand (AD)/real GDP (f) *at in aggregate demand (AD)/real GDP (Y) the price level (PL)/inflation t aggregate supply (AS) t unemployment j the federal funds rate t the nominal then real interest rate to t interest-sensitive spending to j an j in aggregate demand (AD)/real GDP (f)