Question

In recent years, economists have argued about the true value of the real interest rate at any one time and over time. Given that Nominal interest rate \(=\) Real interest rate \(+\) Expected inflation rate, it follows that Real interest rate \(=\) Nominal interest rate \(-\) Expected inflation rate. Why do you think that there is so much disagreement over the true value of the real interest rate?

Short answer

Disagreements over the true value of the real interest rate often result from differing expectations about inflation. Since the real interest rate is the nominal interest rate adjusted for expected inflation, varying predictions about future inflation lead to different calculations of the real interest rate. This, in turn, impacts economic forecasts, borrowing costs, and decisions made by investors and households.

Step-by-step solution

Understanding the Distinction

Firstly, it is essential to understand the distinction between Nominal interest rate and Real interest rate. Nominal interest rate is the rate of interest before accounting for inflation, whereas real interest rate is the nominal interest rate adjusted for the effects of inflation. Here, the formula used is Real Interest Rate = Nominal Interest Rate - Expected Inflation Rate. In practical terms, this means if the nominal interest rate is 5% and inflation is 2%, the real interest rate is 3%.

Identifying factors affecting the disagreement

The disagreements over the real interest rate arises due to variances in the expected inflation rate. Inflation rate is not a constant factor and there might be different predictions about its level. Hence, even if we know the nominal interest rate, the real interest rate can be different depending on the expected inflation rate.

Understanding the consequences of such disagreement

These disagreements can have several important implications. They can lead to differing predictions about the economy's future course and the cost of borrowing. Furthermore, it also affects the decisions of investors and households regarding saving and investing.

Key concepts

Nominal Interest Rate

The nominal interest rate is the percentage that banks or other financial institutions advertise and charge on the amount of money you borrow or save. Simply put, it's the original interest rate you see before considering all other external factors like inflation. When you take a loan or save money, the bank might say, 'We offer a 5% interest rate.' This 5% is the nominal interest rate. It does not take into account the purchasing power of the money.
In our day-to-day financial decisions, knowing the nominal interest rate helps us understand the surface level of our loans or investments. It is straightforward but not entirely accurate for long-term financial planning because it overlooks inflation. If inflation is present, which it often is, your real earnings or the actual cost of borrowing can be significantly different from the nominal rate.

Understanding the nominal interest rate is essential, but to get a clearer picture of the money's value over time, you need to consider the real interest rate.

Expected Inflation Rate

Inflation signifies the rate at which the general price level for goods and services is rising, consequently eroding the purchasing power of currency. The expected inflation rate, therefore, is an estimate of future inflation and reflects how the value of money is perceived to change over time.
Economists and financial analysts spend a significant amount of time trying to predict the expected inflation rate because it's a key factor in setting monetary policies and interest rates. However, it's based on predictions — and predictions can vary based on different economic models, assumptions, and interpretations of data. This is why there can be such intense disagreement among experts about the accurate rate.

For example, if inflation is expected to rise, the real interest rate can be lower, even if the nominal interest rate stays the same. This change affects everything from the cost of borrowing to the value of savings and is a fundamental concept for understanding long-term financial health.

Economy Predictions

Predicting economic trends is akin to forecasting the weather: it's complex, reliant on a multitude of variables, and never guaranteed to be accurate. Economists examine indicators like GDP growth, unemployment rates, and consumer spending to make educated guesses about the future state of the economy.

Why Are Predictions Challenging?

Economic predictions present challenges due to the dynamic and interconnected nature of global markets. For instance, a political event in one country can have a ripple effect globally. Additionally, unexpected occurrences, such as a pandemic or natural disaster, can derail the most solid predictions.
Economic predictions are vital for government and business planning. They influence monetary policy, fiscal policy, and investment strategies. People use these predictions to make decisions about everything from setting interest rates to choosing career paths. However, because there is such a large scope for difference in opinion and analysis, debates over economic predictions are constant and can significantly affect perceptions of the real interest rate.

Cost of Borrowing

The cost of borrowing is essentially how much it costs you to borrow money. This cost is not just the interest you pay back on top of the loan; it also includes any fees or additional charges associated with the loan. The real interest rate, which subtracts the expected inflation rate from the nominal interest rate, plays a critical role here.
For individuals and businesses, understanding the real cost of borrowing is necessary for making sound financial decisions. A lower real interest rate means cheaper loans, which can encourage spending and investment. Conversely, a higher real interest rate can dampen economic activity by making loans more expensive.

The cost of borrowing is not static; it fluctuates with changes in monetary policy, economic conditions, and inflation expectations. This is why the disagreement over the real interest rate is so significant — it directly impacts how much individuals and businesses end up paying when they borrow money. Accurately predicting the expected inflation rate is crucial for determining the true cost of borrowing, as it influences the real interest rate you'll pay on your mortgage, car loan, or business loan.