THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 676

644 PA R T V I I Monetary Theory There is a second, potentially more important reason why the early Keynesian structural model s focus on nominal interest rates provides a misleading picture of the tightness of monetary policy during the Great Depression In a period of deflation, when there is a declining price level, low nominal interest rates not necessarily indicate that the cost of borrowing is low and that monetary policy is easy in fact, the cost of borrowing could be quite high If, for example, the public expects the price level to decline at a 10% rate, then even though nominal interest rates are at zero, the real cost of borrowing would be as high as 10% (Recall from Chapter that the real rate equals the nominal rate, 0, minus the expected rate of inflation, 10%, so the real rate equals ( 10%) = 10%.) You can see in Figure 25-1 that this is exactly what happened during the Great Depression in the United States Real interest rates on U.S treasury bills were far higher during the 1931 1933 contraction phase of the Depression than was the case throughout the next 40 years.2 As a result, movements of real interest rates Annual Interest Rate (%) 16 12 Great Depression Estimated Real Interest Rate 4 Nominal Interest Rate 1932 1933 1934 1940 FIGURE 25-1 1950 1960 1970 1980 1990 2000 2005 2010 Real and Nominal Interest Rates on Three-Month Treasury Bills, 1931 2008 Sources: Nominal rates from www.federalreserve.gov/releases/h15/update/ The real rate is constructed using the procedure outlined in Frederic S Mishkin, The Real Interest Rate: An Empirical Investigation, Carnegie-Rochester Conference Series on Public Policy 15 (1981): 151 200 This involves estimating expected inflation as a function of past interest rates, inflation, and time trends and then subtracting the expected inflation measure from the nominal interest rate In the 1980s, real interest rates rose to exceedingly high levels, approaching those of the Great Depression period Research has tried to explain this phenomenon, some of which points to monetary policy as the source of high real rates in the 1980s For example, see Olivier J Blanchard and Lawrence H Summers, Perspectives on High World Interest Rates, Brookings Papers on Economic Activity (1984): 273 324; and John Huizinga and Frederic S Mishkin, Monetary Policy Regime Shifts and the Unusual Behavior of Real Interest Rates, Carnegie-Rochester Conference Series on Public Policy 24 (1986): 231 274