Inflation and the Real Interest Rate. Control of Inflation

Borrowers and savers may be winners or losers, depending on the rate of inflation. Understanding how this might happen requires making a distinction between the nominal interest rate and the real interest rate. The nominal interest rate is the actual rate of interest earned over a period of time. The nominal interest rate, for example, is the interest rate specified on a loan or savings account. The real interest rate is the nominal interest rate minus the inflation rate. The occurrence of inflation means that the real rate of interest will be less than the nominal rate

During the late 1970s, the rate of inflation rose frequently. This forced mortgage lenders to protect themselves against declining real interest rates on their loans by offering adjustable-rate mortgages (ARMs) in addition to conventional fixed-rate mortgages. A nest egg in the form of a savings account set aside for a rainy day is also affected by inflation. If the inflation rate exceeds the nominal rate of interest, the real interest rate is negative, and the saver is hurt because the interest earned does not keep pace with the inflation rate.

Conclusion: When the real rate of interest is negative, lenders and savers lose because interest earned does not keep up with the inflation rate.

One of the most prominent objectives of macro-economic policy in recent years in Britain has been the need to control inflation. The government has sought to establish a credible monetary policy framework for controlling inflation in three ways:

(1) by setting a symmetrical inflation target of 2.5% per annum so that deviations below the target are treated in the same way as deviations above the target. This helps to ensure that monetary policy not only delivers price stability, but also supports growth and employment. (The Bank of England and the Bank of Canada have symmetrical inflation targets. In contrast, the European Central Bank has a non-symmetrical inflation target – it is compelled to take action only when inflation is too high);

(2) by giving operational independence to the Bank of England (more specifically, its Monetary Policy Committee (MPC) to set the appropriate level of interest rates to attain the inflation target. MPC meets monthly to determine the level of short-term interest rates for the coming month;

(3) by establishing a framework that is open, accountable and transparent. The minutes of the MPC’s monthly meetings are published shortly after each meeting. In addition, if the inflation rate goes beyond 1 percentage point either side of the target, the governor of the Bank of England has to write an open letter to the chancellor explaining the reasons for the failure to meet the target, and setting out the steps that will be taken to bring the inflation rate back into line.

Having interest rates set by an independent body responsible solely for achieving the inflation target without political interference should convince the markets of the government’s long-term commitment to maintaining low inflation.

Ex. 1. Match the Russian word combinations with their English equivalents.

A	B
сберегательный, накопительный счет	adjustable-rate mortgage
ипотечный заимодатель/кредитор	nest egg
ипотека с фиксированной процентной ставкой	saving account
ипотека с регулируемой процентной ставкой	mortgage lender
сбережения, отложенные «на черный день»	fixed-rate mortgage
протокол собрания, заседания	framework
симметричный запланированный/целевой уровень инфляции	minutes of the meeting
структура, система	symmetrical inflation target

Ex. 2. Choose the correct answer:

1. If the nominal rate of interest is less than the inflation rate,

1. lenders win;

2. savers win;

3. the real interest rate is negative;

4. the economy is at full employment.

2. When the inflation rate rises, the purchasing power of nominal income

1. remains unchanged;

2. decreases;

3. increases;

4. changes by the inflation rate minus one.

3. Control of inflation in Britain is carried out by:

1. by setting a symmetrical inflation target of 2.5% per annum;

2. by giving operational independence to the Bank of England;

3. by establishing an open, accountable and transparent framework;

4. all of the above.

Ex. 3. Answer the questions:

1. What is the nominal interest rate?

2. How can lenders protect themselves against declining real interest rates on their loans?

3. What are the three ways for controlling inflation within the monetary policy framework of Britain?

4. What is a symmetrical inflation target set for?

5. Why is a low rate of inflation desirable for an economy?

TRANSLATION

A. Translate the text from English into Russian.