Nominal rates, real rates, and expected inflation, the identity underneath monetary policy.
Warming up the engine…
The split between real and nominal interest: the nominal rate equals the real rate plus expected inflation, so lenders quote nominal but care about real.
i = r + πe (exactly: 1+i = (1+r)(1+πe))
If you lend at 5% while inflation runs at 3%, your purchasing power grows only 2%. When expected inflation rises, lenders demand compensation and nominal rates rise roughly one-for-one (the Fisher effect). Surprise inflation, though, transfers wealth from lenders to borrowers because the contract was written before anyone knew.
Ex-ante (expected) versus ex-post (actual) real rates is the distinction markers reward: unexpected inflation is what redistributes between borrowers and lenders.
Now prove you have it
Move the curve to where you think it lands, and get told exactly which part you got right.
Real-world scenarios on this model
Equilibrium at πᵉ 3.0, i 5.0.
Equilibrium: πᵉ* = 3.0, i* = 5.0
Current equations
Lenders care what their money will BUY when repaid. So nominalnominalMeasured in current dollars, unadjusted for inflation. rates carry expected inflationinflationA sustained rise in the overall price level, eroding money's purchasing power. on top of the realrealAdjusted for inflation, measured in actual purchasing power. rate: i = r + πᵉ. Slide expectationsexpectationsBeliefs about the future that shape behavior today, the hinge variable of modern macroeconomics. right and watch nominal rates rise one-for-one.