Question

Use the following information to work. From 2009 through \(2012,\) the long-term real interest rate paid by the safest U.S. corporations fell from 4 percent a year to 2 percent a year. During that same period, the federal funds rate was roughly constant at 0.25 percent a year. What do you think happened to inflation expectations between 2009 and 2012 and why?

Short answer

Inflation expectations increased between 2009 and 2012, because real interest rates decreased while the nominal rate was constant.

Step-by-step solution

Understanding Real Interest Rate

Real interest rate is the interest rate after adjusting for inflation. It can be represented as: \[ \text{Real Interest Rate} = \text{Nominal Interest Rate} - \text{Inflation Rate} \] Given that the real interest rate fell from 4% to 2%, this implies changes in other economic factors.

Federal Funds Rate

The federal funds rate remained constant at 0.25% during 2009 to 2012. This rate is a short-term interest rate, not directly reflecting long-term real interest rates.

Connecting Real Interest Rate to Inflation

Given that the real interest rate fell but the federal funds rate stayed constant, it suggests changes in inflation expectations. Since the real interest rate is the nominal rate minus inflation, a falling real interest rate during stable nominal rates implies that inflation expectations must have increased.

Conclusion on Inflation Expectations

Between 2009 and 2012, inflation expectations must have risen. This is because the decrease in real interest rates, while nominal rates remain constant, logically infers an increase in expected inflation.

Key concepts

real interest rate

The real interest rate is a key economic concept that helps you understand the true cost of borrowing money.
It is the nominal interest rate adjusted for inflation. Calculating the real interest rate gives you a clearer picture of the purchasing power of the money you will have in the future.
To calculate the real interest rate, use the formula: \[ \text{Real Interest Rate} = \text{Nominal Interest Rate} - \text{Inflation Rate} \]
For example, if the nominal interest rate is 5% and the inflation rate is 2%, the real interest rate would be 3%.
This tells you that after accounting for inflation, the true cost of borrowing money is 3%.
The real interest rate is crucial for investors and borrowers alike. It helps investors understand their true earning potential and helps borrowers understand the true cost of their loans.

inflation expectations

Inflation expectations refer to what people in the market predict will happen to prices in the future.
These expectations are vital because they influence economic decisions such as spending, saving, and investing.
If people expect higher inflation, they may be more likely to buy goods and services now, rather than later when prices might be higher.
Conversely, if they expect lower inflation, they might delay spending.
Inflation expectations can be measured various ways, including surveys and market-based measures like the spread between nominal and inflation-protected bonds.
Between 2009 and 2012, the real interest rate fell from 4% to 2% while the federal funds rate remained constant. This suggests that inflation expectations were rising during this period.
For the real interest rate to fall while nominal rates stay constant, people must expect higher inflation.

federal funds rate

The federal funds rate is the short-term interest rate at which banks lend funds to each other overnight.
It is one of the most important indicators of the monetary policy's stance.
The Federal Reserve (the Fed) influences this rate to help regulate the economy.
If the Fed wants to stimulate the economy, it might lower the federal funds rate. A lower rate makes borrowing cheaper, encouraging spending and investment.
On the other hand, if the Fed wants to cool down an overheating economy, it might raise the federal funds rate to make borrowing more expensive.
From 2009 to 2012, the federal funds rate was roughly constant at 0.25% a year.
Even though the federal funds rate is a short-term rate, it can influence other interest rates in the economy, but it does not directly affect long-term real interest rates.

nominal interest rate

The nominal interest rate is the interest rate before taking inflation into account.
It is the rate that you typically see quoted by banks and lenders.
For instance, if you take out a loan with a 5% interest rate, that's the nominal rate.
However, the nominal interest rate does not give the whole picture because it does not account for inflation. For example, if inflation is at 2%, the real cost of your loan is reduced because the value of money decreases.
The relationship between nominal interest rate, real interest rate, and inflation can be expressed as: \[ \text{Real Interest Rate} = \text{Nominal Interest Rate} - \text{Inflation Rate} \]
Understanding the nominal rate helps you better grasp the concept of real interest rates.
In summary, while the nominal interest rate tells you how much you're earning or paying in dollars, the real interest rate tells you the true value of those dollars after inflation.