Question

The chapter states that it is impossible to know whether a particular nominal interest rate is "high" or "low." Briefly explain why.

Short answer

Nominal interest rates cannot be judged as 'high' or 'low' because they do not account for inflation. An apparent high nominal interest rate could translate to a low real interest rate in a high inflation environment, and vice versa. Therefore, without considering the rate of inflation, it's impossible to accurately judge whether a nominal interest rate is 'high' or 'low'.

Step-by-step solution

Understanding Nominal Interest Rate

Nominal Interest Rate is the interest rate without accounting for inflation. It is the percentage change in the amount of money you have. However, it neither reflects the purchasing power of that money nor the actual increase in goods or services that money can buy. Therefore, the nominal interest does not provide the complete picture of the economic situation.

Connecting Nominal Interest Rate and Inflation

Inflation reduces the power of each unit of currency. This means that even if the amount of money you have increases - due to interest - the number of goods or services you can buy with that money may remain the same or even decrease if the rate of inflation is greater than the interest rate. This is why an understanding of inflation is key when looking at interest rates.

Explaining why a Nominal Interest Rate can't be judged as 'high' or 'low'

Because Nominal Interest Rate doesn't account for inflation, it cannot be inherently judged as 'high' or 'low'. Nominal Interest Rates can appear high but if inflation is also high, the real interest rate (which accounts for inflation) could be low or even negative. Conversely, nominal rates can appear low, but if inflation is very low or negative (deflation), the real interest rate could be high. Therefore, without knowing the inflation rate, a judgment cannot be made on whether the nominal interest rate is 'high' or 'low'.

Key concepts

Inflation

Inflation is the ongoing rise in the prices of goods and services over time. This means that as inflation increases, each unit of currency buys fewer goods and services.
Inflation is usually expressed as an annual percentage rate. For example, if inflation is 3%, a given basket of goods and services will cost 3% more in the following year than it did in the current year.
Factors that contribute to inflation include:

• Demand-pull inflation: Occurs when demand for goods and services exceeds their supply.
• Cost-push inflation: Happens when the costs to produce goods and services rise, leading businesses to pass on those costs to consumers.
• Built-in inflation: Expectations of future inflation can lead to current inflation. For example, if people expect inflation to rise, they may demand higher wages, leading companies to increase prices.

Understanding inflation is crucial because it can significantly impact the economy and your purchasing power. During periods of high inflation, money loses value quickly, decreasing the real returns on savings.

Real Interest Rate

The real interest rate is the interest rate that has been adjusted for inflation. It reflects the true cost of borrowing and the true return on investing, in terms of purchasing power.
To calculate the real interest rate, subtract the inflation rate from the nominal interest rate.
This is expressed by the equation:
\( \text{Real Interest Rate} = \text{Nominal Interest Rate} - \text{Inflation Rate} \)
Real interest rates provide a more accurate representation of the economic situation compared to nominal rates. For example, if the nominal interest rate is 5% and the inflation rate is 3%, the real interest rate is 2%. This tells you that the actual growth in purchasing power, after accounting for inflation, is 2%.
Real interest rates can be zero or negative if inflation outpaces nominal interest rates. This scenario often signifies an environment where savings may lose value over time.

Purchasing Power

Purchasing power refers to how much money you need to buy goods and services. Higher purchasing power means you can buy more with a given amount of money, while lower purchasing power means you buy less.
It's crucial to consider purchasing power when evaluating personal finances or the economy because it directly affects your standard of living. Inflation can erode purchasing power if income does not increase at the same rate as prices.
For example:

• If your income rises by 2% over a year, but inflation is 3%, your purchasing power has decreased, making it harder to afford the same lifestyle.
• Conversely, if inflation is lower than your income growth, your purchasing power increases, potentially allowing for a better quality of life.

Understanding purchasing power helps you to budget effectively and make wise investment choices that maintain or enhance your financial well-being.