Because in the AS\AD model monetary policy works through the effect of interest rate on investment, our analysis focuses on the interest rate in judging monetary policy. A rising interest rate indicates a tightening of monetary policy. A falling interest rate indicates a loosening of monetary policy.

A natural conclusion is that the fed should target interest rates in setting monetary policy, for example, if the interest rate is currently 6 percent and fed wants to loosen monetary policy, it should buy bonds until the interest rate falls to, say,5.5 percent. If it wants to tighten monetary policy, it should sell bonds to make the interest rate go up to, say 6.5 percent.

There is a problem in using interest rates to measure whether monetary policy is contraction or expansionary. That problem is the real\nominal interest rate problem.

Nominal interest rates are the rates you actually see and pay. When a bank pays 7 percent interest, that 7 percent is nominal interest rate. What affects the economy is the real interest rate. Real interest rates are nominal interest rates adjusted for expected inflation.

For example, you get 7 percent interest from the bank, but the price level goes up 7 percent. At the end of the year you have $107 instead of $100, but you are no better off than before because the price level has risen-on average, things cost 7 percent more. What you would have paid $100 for last year now costs $107. (That's the definition of inflation.) Had the price level remained constant, and had you received o percent interest, you would be in the equivalent position to receiving 7 percent interest on your 100$when the price level rises by 7 percent. That o percent is the real interest rate. It is the interest rate you would expect to receive if the price level remains constant.

The real interest cannot be observed because it depends on expected inflation. To calculate the real interest rate, you must subtract what you believe to be the expected rate of inflation from the nominal interest rate. For example, if the nominal interest rate is 7 percent and expected inflation is 4 percent, the real interest rate is 3 percent. The relationship between real and nominal interest rates is important both for you study of economic and for your own personal finances:

Nominal interest rate = real interest rate + Expected inflation rate.

## Thursday, July 9, 2009

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