given market price for the product they sell, but that price is determined
in equilibrium through the interaction of demand and supply.
One thing should be mentioned before we go on. In this chapter we have
spent much time discussing the role of the interest rate in determining
how firms and households behave. But we have ignored an important
distinction between the nominal interest rate and the real interest rate.
The nominal interest rate is the rate stated in the loan agreement. The
interest rate adjusts the nominal interest rate for the effects of inflation,
and better represents the true cost of borrowing. The real interest rate is
approximately equal to the nominal interest rate minus the rate of
inflation. Applying Economic Concepts 15-1 examines this distinction in
more detail. In the discussion that follows, we restrict our attention to the
real interest rate.
Applying Economic Concepts 15-1
Inflation and Interest Rates
Inflation means the prices of all goods in the economy are
rising. More correctly, it means that the prices of goods are
rising on average—some prices may be rising and others may
be falling, but if there is inflation then the average price is
rising. Economists refer to the average price of all goods as the
price level. When the price level is rising, inflation is positive; if
prices are rising at a rate of 5 percent per year, the rate of