4.6.3 Expectations And Interest Rates

Expectations and Interest Rates

Investment decisions are inherently forward-looking since any decision to purchase a security is based on an expectation of its future return. Increased optimism in the market can generate a rise in stock prices, whereas pessimism can stall economic growth and, thus, decrease share prices. Government economic policies also significantly impact people’s expectations. For instance, the Bank of Canada strives to maintain credibility in its commitment to lower the inflation rate, influencing market sentiments and expectations.

The Role of Expected Inflation

The concept of expected inflation is crucial in determining the level of nominal interest rates. Earlier, we discussed the difference between nominal GDP and real GDP—primarily the effect of inflation. The same concept applies here. The nominal interest rate refers to the rate where the effect of inflation has not been removed. The rate charged by a bank on a loan is the nominal interest rate, as is the quoted rate on an investment such as a guaranteed investment certificate (GIC) or Treasury bill.

Under typical conditions, a higher rate of inflation leads to a higher nominal interest rate. In contrast, the real interest rate can be approximated by subtracting the expected inflation rate from the nominal interest rate.

Formula: Real Interest Rate

The real interest rate can be calculated using the following formula, known as the Fisher Equation:

Where:

• \(R_{real}\) is the real interest rate
• \(R_{nominal}\) is the nominal interest rate
• \(I_{expected}\) is the expected inflation rate

Example Calculation

Assume that you need to earn a real rate of return of 6% from your investments to fund your retirement goals. If an inflation rate of 3% is expected, you should seek investments that offer a nominal rate of return of 9% (6% real rate of return + 3% expected inflation rate).

Dive Deeper: The Fisher Equation

For those interested in a more comprehensive understanding, researching the Fisher Equation can provide a deeper insight. While the rough approximation of applying the basic formula in this course is practical, the Fisher Equation presents a more precise model for calculating real interest rates.

Impacts of Government Economic Policies

The effect of governmental economic policies, like those of the Bank of Canada, can both direct and indirectly influence interest rates through their impact on inflation and broader economic expectations. The credibility and effectiveness of these policies in controlling inflation and stabilizing the economy can lead to direct shifts in market expectations, thereby impacting nominal and real interest rates.

Key Takeaways

• Investment decisions are primarily based on expectations about future returns.
• The role of expected inflation in determining nominal interest rates is significant.
• Nominal interest rates increase with higher expected inflation rates, while real interest rates provide a better measure of true return on investment by accounting for inflation.
• The Fisher Equation can be used for more precise calculations of real interest rates:

$$ R_{real} = R_{nominal} - I_{expected} $$

• Government economic policies play a critical role in shaping market expectations and influencing interest rates.

Glossary

Nominal Interest Rate: The rate at which interest is paid by borrowers for the use of money that they borrow, unadjusted for inflation.

Real Interest Rate: The rate of interest an investor expects to receive after allowing for inflation.

Expected Inflation Rate: The rate at which prices for goods and services are expected to increase in the future.

Fisher Equation: An economic theory that describes the relationship between nominal and real interest rates under inflation.

Frequently Asked Questions (FAQs)

Q1: Why is expected inflation crucial for determining interest rates?

A1: Expected inflation is crucial because it affects the nominal interest rate, which incorporates the expected increase in prices. This ensures that lenders and investors maintain a return on their investment adjusted for the devaluation of currency due to inflation.

Q2: How does the Bank of Canada influence market expectations?

A2: The Bank of Canada influences market expectations through its monetary policies aimed at controlling inflation, maintaining currency stability, and fostering economic growth. Credible and consistent policies can enhance market optimism, whereas contradictory policies might breed uncertainty.

Q3: What is the difference between nominal and real interest rates?

A3: The nominal interest rate is the rate at which borrowers pay interest without adjusting for inflation. In contrast, the real interest rate subtracts the expected inflation rate from the nominal rate to reflect the true cost of borrowing or the true return on an investment adjusted for inflation.