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INFLATION AND INTEREST RATES

Interest rates in Mexico in 1999 were about 25.25 percent. So why didn`t you (and a few million other investors) put your cash in a Mexican bank deposit where the return seemed to be so attractive?

The answer lies in the distinction that we made earlier between nominal and real rates of interest. Bank deposits usually promise you a fixed nominal rate of interest but they don`t promise what that money will buy. If you invested 100 pesos for a year at an interest rate of 25.25 percent, you would have 25.25 percent more pesos at the end of the year than you did at the start. But you wouldn`t be 25.25 percent better off. A good part of the gain would be needed to compensate for inflation.

The nominal rate of interest in 1999 was much lower in the United States, but then so was the inflation rate. The real rates of interest were much closer than the nominal rates.

There is a general law at work here. Just as water always flows downhill, so capital always flows where returns are greatest. But it is the real returns that concern investors, not the nominal returns. Two countries may have different nominal interest rates but the same expected real interest rate.

Do you remember Irving Fisher`s theory that changes in the expected inflation rate are reflected in the nominal interest rate? We have just described here the international Fisher effect ¤international variations in the expected inflation rate are reflected in the nominal interest rates: In other words, capital market equilibrium requires that real interest rates be the same in any two countries.

International Fisher Effect

If the nominal interest rate in Mexico is 25.25 percent and the expected inflation is 20 percent, then

In the United States, where the nominal interest rate is about 6 percent and the expected inflation rate is about 2 percent,

The real interest rate is higher in Mexico than in the United States, but the difference in the real rates is much smaller than the difference in nominal rates.

How similar are real interest rates around the world? It is hard to say, because we cannot directly observe expected inflation. In Figure 6.3 we have plotted the average interest rate in each of 40 countries against the inflation that in fact occurred. You can see that the countries with the highest interest rates generally had the highest inflation rates.

INTERNATIONAL FISHER EFFECT Theory that real interest rates in all countries should be equal, with differences in nominal rates reflecting differences in expected inflation.