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 do 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 4 that the real rate equals the nominal rate, 0, minus the expected rate of
inflation, 10%, so the real rate equals 0 ( 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

8

4

0

4
Nominal Interest Rate
8

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.

2

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 2
(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.