Natural rate theory also views attempts to achieve lower interest rates than are consistent with individual's decisions as ultimately self-defeating. We will now examine why the natural real rate hypothesis identifies the interest rate as an inappropriate target for monetary authorities.

 

The Natural "Real" Rate of Interest Hypothesis

 

When people discuss "the" interest rate, they usually mean the average annual percentage monetary premium paid for the use of money. However, interest rates vary almost as much as wage rates or other prices. The different interest rates paid by borrowers to lenders reflect, among other considerations, risk, length of time to maturity of the note or bond, the availability of credit, applicable tax rates, and legal constraints. For simplicity, however, we will assume that there is only one interest rate for borrowing. Economists refer to these percentage monetary premiums as nominal rates of interest.

The real rate of interest is the annual percentage of purchasing power paid by a borrower to a lender for the use of money.

 

            Estimating realized real rates of interest (r) is simple---the nominal interest rate (i) minus the percentage rate of inflation (p) yields the percentage purchasing power premium, or real interest rate (r), paid over the life of a note or bond:

 

r = i - p

For example, if nominal interest is 8 percent and the price level rises 10 percent annually, the real rate of interest is roughly -2 percent, so lenders lose 2 percent of purchasing power each year.

 

            Workers who expect inflation will bargain for higher nominal wages in order to protect their real wages. Naturally, people whose incomes are based on interest react similarly. The natural rate hypothesis suggests that borrowers and lenders adjust nominal interest to expected inflation E(p), so that the willingness of borrowers to pay purchasing power premiums (desired real interest, rd) exactly equals the purchasing power premiums lenders require for the use of money. Thus, when a note or bond is issued:

i = rd + E(p)

If inflation is expected, lenders try to charge higher interest to ensure that they will not lose purchasing power, but why will borrowers be willing to pay such "high" interest rates? To understand this essential point, consider the housing market during the late 1970s, during which housing prices increased by from 10 to 30 percent annually in some regions.

 

            Suppose that you expect housing prices in your area to increase by 15 percent annually. To keep it simple, we will assume that you can borrow money at a nominal interest rate of 10 percent. If you are able to repay the loan with dollars that have depreciated in value by 15 percent annually, this situation is similar to being paid 5 percent of the price of your house annually to live in your own home. Negative real rent sounds pretty good to most of us, which explains, in part, why housing prices have boomed in some areas in recent years.

 

            The natural rate theory of real interest suggests that the desired real rate of interest (rd) reflects (a) purchasing power premiums needed to induce savers to delay gratification (most of us value having good today more than having the same good tomorrow), (b) premiums needed to induce people to hold wealth in less liquid forms, and (c) the expected productivity of new capital, which yields extra goods in the future. The real interest rate is the percentage of extra goods that can be enjoyed if consumption is delayed so that extra capital is available for production.