[djsheen]

If expected inflation is 3% and the nominal interest rate is 6%, what is the real rate of interest? If actual inflation turns out to be only 2%, explain who benefits and who loses.

[ebaines]

Sounds like a homework problem to me.

Think about this - if you get 6% return from the bank but your purchasing power is eroded by 3% due to inflation while your moiney was tied up in the bank, how much extra purchasing power do you actually have from your investment? The answer is pretty obvious.

If inflation is "only" 2%, you do a bit better, don't you?

[djsheen]

Sounds like a homework problem to me.

Think about this - if you get 6% return from the bank but your purchasing power is eroded by 3% due to inflation while your moiney was tied up in the bank, how much extra purchasing power do you actually have from your investment? The answer is pretty obvious.

If inflation is "only" 2%, you do a bit better, don't you?

Yes, it's a homework question
I put 3%
The question really is who benefits and who loses
Consumers seem to win as goods are cheaper
Who loses... that's where I'm confused

[ebaines]

I suppose one could argue that if inflation is lower then it's harder for the bank to come up with that 6% to pay you, as presumably there are fewer customers willing to take out new loans at > 6%. So if you have that 6% locked in, the bank gets squeezed a bit. But again, this presumes that that the rate banks loan money at is exactly tied to the inflation rate, but it's more complicated than that.

[djsheen]

I suppose one could argue that if inflation is lower then it's harder for the bank to come up with that 6% to pay you, as presumably there are fewer customers willing to take out new loans at > 6%. So if you have that 6% locked in, the bank gets squeezed a bit. But again, this presumes that that the rate banks loan money at is exactly tied to the inflation rate, but it's more complicated than that.

well, here's my answer - a bit long as you'll see:
The real rate of interest is 3%. The interest rate containing the real rate of interest and a premium to cover expected inflation is often called the nominal risk-free rate of interest. The nominal interest rate is the real interest rate plus a number of premiums. The major premiums are the inflation premium, the default risk premium, the liquidity risk premium and the maturity risk premium.

Interest rates are actually calculated as two different values: the nominal rate and the real rate. The nominal rate is the interest rate set by the lending institution. The real rate is the nominal rate minus the rate of inflation. For example, if you take out a mortgage with a nominal interest rate of 10 percent, but the annual rate of inflation is four percent, then the bank is only really collecting six percent on the loan
When inflation is present, the dollars that lenders get when their loans are repaid may not buy as much as the dollars that they lent to start with. High interest rates and slow growth of the money supply are the traditional ways through which central banks fight or prevent inflation. Meanwhile, interest rates directly affect the credit market because higher interest rates make borrowing more costly. By changing interest rates, the Bank of Canada tries to achieve maximum employment, stable prices and a good level of growth. When interest rates go down, people and businesses are encouraged to borrow and spend more, boosting the economy. But if the economy grows too fast, it can lead to inflation. The Bank may then raise interest rates to slow down borrowing and spending, putting a brake on inflation.
If inflation goes down, it means that consumers’ purchasing power may increase, stimulating economic growth. Lower inflation means less grinding away at the value of investments. High or unpredictable inflation rates are regarded as bad for reasons such as:
• Uncertainty about future inflation may discourage investment and saving.
• Redistribution - debtors may be helped by inflation due to reduction of the real value of debt burden.
• International trade: Where fixed exchange rates are imposed, higher inflation than in trading partners' economies will make exports more expensive and tend toward a weakening balance of trade.
• Cost-push inflation: Rising inflation can prompt trade unions to demand higher wages, to keep up with consumer prices. Rising wages in turn can help fuel inflation.
• Hyperinflation: if inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply.
• With high inflation, firms must change their prices often in order to keep up with economy wide changes.

Some possibly positive effects of (moderate) inflation include:
• Labor Market Adjustments: some inflation is good for the economy, as it would allow labor markets to reach equilibrium faster.
• Room to maneuver: A moderate level of inflation tends to ensure that nominal interest rates stay sufficiently above zero so that if the need arises the bank can cut the nominal interest rate.

am I way off course?

[excon]

if you take out a mortgage with a nominal interest rate of 10 percent, but the annual rate of inflation is four percent, then the bank is only really collecting six percent on the loan

Hello dj:

In your example above, who do you think is getting the other 4%? It's the government, because inflation is a hidden and illegal tax that transfers wealth from the people to the government. I say hidden, because only a few people understand it, and illegal because the congress didn't pass it.

You also infer that inflation is controlled by interest rates. That's the current wisdom, but it's not so. Inflation is controlled by the money supply. If you inflate the money supply, wages and prices are soon to follow.

Some people think that's good. Then there are people like me, who think it's bad.

That, my friend, is NOT rocket science.

But, in answer to your question, NET borrowers benefit from inflation, because they pay back their loans with cheaper dollars. The US government is the worlds largest debtor, and THAT'S why it inflates - so it can pay back the lenders with cheaper dollars. And rip them off in the process, since the government can print as many dollars as it wants.

excon