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NOMINAL AND REAL RATES OF INTEREST

Earlier we drew a distinction between nominal and real rates of interest. The cash flows on the 6 percent Treasury bonds are fixed in nominal terms. Investors are sure to receive an interest payment of $60 each year, but they do not know what that money will buy them. The real interest rate on the Treasury bonds depends on the rate of inflation. For example, if the nominal rate of interest is 5.6 percent and the inflation rate is 3 percent, then the real interest rate is calculated as follows:

Since the inflation rate is uncertain, so is the real rate of interest on the Treasury bonds. You can nail down a real rate of interest by buying an indexed bond, whose payments are linked to inflation. Indexed bonds have been available in some countries for many years, but they were almost unknown in the United States until 1997 when the U.S. Treasury began to issue inflation-indexed bonds known as Treasury Inflation- Protected Securities, or TIPS. The cash flows on TIPS are fixed, but the nominal cash flows (interest and principal) are increased as the consumer price index increases. For example, suppose the U.S. Treasury issues 3 percent, 2-year TIPS. The real cash flows on the 2- year TIPS are therefore

The nominal cash flows on TIPS depend on the inflation rate. For example, suppose inflation turns out to be 5 percent in Year 1 and a further 4 percent in Year 2. Then the nominal cash flows would be

These cash payments are just sufficient to provide the holder with a 3 percent real rate of interest.

As we write this in mid-1999, three-year TIPS offer a yield of 3.9 percent. This yield is a real interest rate. It measures the amount of extra goods your investment will allow you to buy. The 3.9 percent real yield on TIPS is 1.7 percent less than the 5.6 percent yield on nominal Treasury bonds.5 If the annual inflation rate proves to be higher than 1.7 percent, you will earn a higher return by holding TIPS; if the inflation rate is lower than 1.7 percent, the reverse will be true. The nearby box discusses the case for investments in TIPS.

Real interest rates depend on the supply of savings and the demand for new investment. As this supply demand balance changes, real interest rates change. But they do so gradually. We can see this by looking at the United Kingdom, where the government has issued indexed bonds since 1982. The red line in Figure 3.8 shows that the (real) interest rate on these bonds has fluctuated within a relatively narrow range.

Suppose that investors revise upward their forecast of inflation by 1 percent. How will this affect interest rates? If investors are concerned about the purchasing power of their money, the changed forecast should not affect the real rate of interest. The nominal interest rate must therefore rise by 1 percent to compensate investors for the higher inflation prospects.

The blue line in Figure 3.8 shows the nominal rate of interest in the United Kingdom since 1982. You can see that the nominal rate is much more variable than the real rate. When inflation concern was near its peak in the early 1980s, the nominal interest rate was almost 10 percent above the real rate. As we write this in mid-1999, inflation fears have eased and the nominal interest rate in the United Kingdom is only 21БІАБАД2 percent above the real rate.