Eye Therapies Exhibit 2047, 301 of 702
`Slayback v. Eye Therapies - IPR2022-00142
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`Eye Therapies Exhibit 2047, 302 of 702
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`Eye Therapies Exhibit 2047, 303 of 702
`Slayback v. Eye Therapies - IPR2022-00142
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`

`QUESTIONS FOR DISCUSSION
`
`281
`
` CONCEPTS FOR REVIEW
`
` Land and Natural Resources
` renewable vs. nonrenewable resources
` appropriable vs. inappropriable
`resources
` rent, pure economic rent
` inelastic supply of land
` taxation of fi xed factors
`
` Environmental Economics
` externalities and public goods
` private vs. public goods
` ineffi ciency of externalities
` internal vs. external costs, social vs.
`private benefi ts
`
` remedies for externalities: standards,
`taxes, liability, bargaining
` tradeable emissions permits
` global public goods
`
` FURTHER READING AND INTERNET WEBSITES
`
` Further Reading
` Environmental economics is a rapidly growing fi eld. You
`can explore advanced topics in a textbook such as Thomas
`H. Tietenberg, Environmental Economics and Policy, 7th ed.
`(Addison-Wesley, New York, 2006). An excellent book of
`readings is Robert Stavins, ed., Economics of the Environment:
`Selected Readings , 5th ed. (Norton, New York, 2005).
` The quote from Wilson is from Edward O. Wilson, “Is
`Humanity Suicidal?” New York Times Magazine, May 30, 1993,
`p. 27. The quotation from Julian Simon is from Scarcity or
`Abundance? A Debate on the Environment (Norton, New York,
`1994), available at www.juliansimon.com/writings/Norton/
`NORTON01.txt . The quotation from Ehrlich and Ehrlich is
`from The New York Review of Books, February 14, 2008.
`
` Websites
` One of the best websites on resources and the environment
`is maintained by the nonprofi t organization Resources
`for the Future at www.rff.org . You can consult this site for
`information on a wide range of issues.
` Energy data are available at the Energy Information
`Agency’s comprehensive site at www.eia.doe.gov .
` You can learn more about environmental policy at the U.S.
`Environmental Protection Agency’s website at www.epa.gov .
`International environmental policy is found at the United
`Nations Environmental Program’s site at www.unep.org .
`Information on the Kyoto Protocol and other programs to
`address climate change can be found at www.ipcc.ch and
` www.unfccc.de .
`
` QUESTIONS FOR DISCUSSION
`
` 1. What is the difference between renewable and nonre-
`newable resources? Give examples of each.
` 2. What is meant by an inappropriable natural resource?
`Provide an example and explain why the market allo-
`cation of this resource is ineffi cient. What would be
`your preferred way to improve the market outcome?
` 3. Defi ne “pure economic rent.”
`a.
` Show that an increase in the supply of a rent-
` earning factor will depress its rent and lower the
`prices of the goods that use it.
` Explain the following statement from rent theory:
`“It is not true that the price of corn is high because
`the price of corn land is high. Rather, the reverse is
`
`b.
`
`c.
`
`closer to the truth: the price of corn land is high
`because the price of corn is high.” Illustrate with a
`diagram.
` Consider the quotation in b. Why is this correct for
`the market as a whole but incorrect for the indi-
`vidual farmer? Explain the fallacy of composition
`that is at work here.
` 4. Assume that the supply curve for top baseball players is
`perfectly inelastic with respect to their salaries.
`a.
` Explain what completely inelastic supply means in
`terms of number of games played.
` Next assume that because of television, the
`demand for the services of major-league baseball
`
`b.
`
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`Eye Therapies Exhibit 2047, 304 of 702
`Slayback v. Eye Therapies - IPR2022-00142
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`

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`282
`
`CHAPTER 14
`
`• LAND, NATURAL RESOURCES, AND THE ENVIRONMENT
`
`players increases. What would happen to their sala-
`ries? What would happen to their batting averages
`(other things held constant)? Does this theory fi t
`historical trends?
` 5. Explain why a tax on land rent is effi cient. Compare a
`tax on the land with a tax on the houses on the land.
` 6. “Local public goods” are ones that mainly benefi t the
`residents of a specifi c town or state—such as beaches
`or schools open only to town residents. Is there any
`reason to think that towns might act competitively to
`provide the correct amount of local public goods to
`their residents? If so, does this suggest an economic
`theory of “fi scal federalism” whereby local public goods
`should be locally supplied?
` 7. Decide whether each of the following externalities
`is serious enough to warrant collective action. If so,
`which of the four remedies considered in this chapter
`would be most effi cient?
`a.
` Steel mills emitting sulfur oxides into the Birming-
`ham air
` Smoking by people in restaurants
` Smoking by students without roommates in their
`own rooms
` Driving by persons under the infl uence of alcohol
` Driving by persons under age 21 under the infl u-
`ence of alcohol
` 8. Get your classmates together to do a contingent-
`valuation analysis on the value of the following:
`Prohibiting drilling in all wilderness areas in the
`United States; preventing the extinction of spotted
`owls for another 10,000 years; ensuring that there are
`at least 1 million spotted owls in existence for another
`10,000 years; reducing the chance of dying in an auto-
`mobile accident from 1 in 1000 to 1 in 2000 per year.
`How reliable do you think this technique is for gather-
`ing information about people’s preferences?
` 9. Don Fullerton and Robert Stavins argue that the fol-
`lowing are myths about how economists think about
`
`d.
`e.
`
`b.
`c.
`
`d.
`
`
`
`b.
`
`c.
`
`the environment (see Chapter 1 in the Stavins book in
`the Further Reading section). For each, explain why it
`is a myth and what the correct approach is:
`a.
` Economists believe that the market solves all envi-
`ronmental problems.
` Economists always recommend market solutions
`to environmental problems.
` Economists always use market prices to evaluate
`environmental issues.
` Economists are concerned only with effi ciency and
`never with income distribution.
` 10. Advanced problem: Global public goods pose special
`problems because no single nation can capture all the
`benefi ts of its own pollution-control efforts. To see this,
`redraw Figure 14-5 , labeling it “Emissions Reduction
`for the United States.” Label all the curves with “US”
`to indicate that they refer to costs and benefi ts for
`the United States alone. Next, draw a new MSB curve
`which is 3 times higher than the MSB US at every point
`to indicate that the benefi ts to the world are 3 times
`higher than those to the United States alone. Consider
`the “nationalistic” equilibrium at E where the United
`States maximizes its own net benefi ts from abatement.
`Can you see why this is ineffi cient from the point of
`view of the entire globe? ( Hint: The reasoning is analo-
`gous to that in Figure 14 -3 .)
`
` Consider this issue from the point of view of game
`theory. The Nash equilibrium would occur when
`each country chose the nationalistic equilibrium you
`have just analyzed. Describe why this is analogous to
`the ineffi cient Nash equilibrium described in Chap-
`ter 10—only here the players are nations rather than
`fi rms. Now consider the cooperative game in which
`nations get together to fi nd the effi cient equilibrium.
`Describe the effi cient equilibrium in terms of global
` MC and MSB curves. Can you see why the effi cient
`equilibrium would require a uniform carbon tax in
`each country?
`
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`Eye Therapies Exhibit 2047, 305 of 702
`Slayback v. Eye Therapies - IPR2022-00142
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`

`

`Eye Therapies Exhibit 2047, 306 of 702
`Slayback v. Eye Therapies - IPR2022-00142
`
`

`

`284
`
`CHAPTER 15
`
`• CAPITAL, INTEREST, AND PROFITS
`
`Payments for the temporary use of capital goods are
`called rentals. An apartment that is owned by Ms.
`Landlord might be rented out for a year to a student,
`and the monthly payment of $800 per month would
`constitute a rental. We distinguish rent on fi xed fac-
`tors like land from rentals on durable factors like
`capital.
`
` Capital vs. Financial Assets
` Individuals and businesses own a mix of different
`kinds of assets. One class is the productive input
`capital that we just discussed—items like computers,
`automobiles, and houses that are used to produce
`other goods and services. But we must distinguish
`these tangible assets from fi nancial assets , which are
`essentially pieces of paper or electronic records.
`More precisely, fi nancial assets are monetary claims
`by one party against another party. An important
`example is a mortgage, which is a claim against
`a homeowner for monthly payments of interest
`and principal; these payments will repay the origi-
`nal loan that helped fi nance the purchase of the
`house.
`
` Often, as in the case of a mortgage, a tangible
`asset will lie behind (or serve as collateral for) a
`fi nancial asset. In other cases, such as student loans,
`a fi nancial asset may derive its value from a prom-
`ise to pay based on the future earning power of
`an individual.
`
` It is clear that tangible assets are an essential part
`of an economy because they increase the productivity
`of other factors. But what function do fi nancial assets
`serve? These assets are crucial because of the mis-
`match between savers and investors. Students need
`money to pay for college, but they do not currently
`have the earnings or the savings necessary to pay the
`bills. Older people, who are working and saving for
`retirement, may have income in excess of their expen-
`ditures and can provide the savings. A vast fi nancial
`system of banks, mutual funds, insurance companies,
`and pension funds—often supplemented by govern-
`ment loans and guarantees—serves to channel the
`funds of those who are saving to those who are invest-
`ing. Without this fi nancial system, it would not be pos-
`sible for fi rms to make the huge investments needed
`to develop new products, for people to buy houses
`before they had saved the entire housing price, or for
`students to go to college without fi rst saving the large
`sums necessary.
`
` The Rate of Return on Investments
` Suppose that you own some capital and rent it out
`or that you have some cash and lend it to a bank or
`to a small business. Or perhaps you want to take out
`a mortgage to buy a house. You will naturally want to
`know what you will pay to borrow or how much you
`will earn by lending. This amount is called the rate
`of return on investments . In the special case of the
`return on fi xed-interest fi nancial assets, these earn-
`ings are called the interest rate . From an economic
`point of view, interest rates or returns on invest-
`ments are the price of borrowing or lending money.
`The returns will vary greatly depending upon the
`maturity, risk, tax status, and other attributes of the
`investment.
`
` We will devote considerable space in this chapter
`to understanding these concepts. The following sum-
`mary highlights the major ideas:
`
` 1. Capital consists of durable produced items that
`are in turn used as productive inputs for the pro-
`duction of other goods. Capital consists of both
`tangible and intangible assets.
` 2. Capital is bought and sold in capital markets. Pay-
`ments for the temporary use of capital goods are
`called rentals.
` 3. We must distinguish fi nancial assets, which are es-
`sentially pieces of paper deriving their value from
`ownership of other tangible or intangible assets.
` 4. The rate of return on investments, and the special
`case of the interest rate, is the price for borrow-
`ing and lending funds. We usually calculate rates
`of return on the funds using units of percent per
`year.
`
` RATES OF RETURN AND
`INTEREST RATES
` We now examine in greater detail the major concepts
`in capital and fi nancial theory. We begin with the
` defi nition of a rate of return on investments, which is
`the most general concept. We then apply these defi -
`nitions to fi nancial assets.
`
` Rate of Return on Capital
` One of the most important tasks of any economy
`is to allocate its capital across different possible
`investments. Should a country devote its investment
`resources to heavy manufacturing like steel or to
`
`
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`
`Eye Therapies Exhibit 2047, 307 of 702
`Slayback v. Eye Therapies - IPR2022-00142
`
`

`

`THE PRESENT VALUE OF ASSETS
`
`285
`
`information technologies like the Internet? Should
`Intel build a $4 billion factory to produce the next
`generation of microprocessors? These questions
`involve costly investments—laying out money today
`to obtain a return in the future.
`
` In deciding upon the best investment, we need a
`measure for the yield or return. One important mea-
`sure is the rate of return on investment , which
`denotes the net dollar return per year for every dol-
`lar of invested capital.
`
` Let’s consider the example of a rental car com-
`pany. Ugly Duckling Rental Company buys a used
`car for $20,000 and rents it out. After subtracting
`all expenses (revenues less expenses such as wages,
`offi ce supplies, and energy costs) and assuming no
`change in the car’s price, Ugly Duckling earns a
`net rental of $2400 each year. The rate of return is
`12 percent per year (12% ⫽ $2400/$20,000). Note
`that the rate of return is a pure or unitless number
`per unit of time. That is, the rate of return has the
`dimensions of (dollars per period)/(dollars), and it
`is usually calculated with units of percent per year.
`
` These concepts are useful for comparing invest-
`ments. Suppose you are considering investments
`in rental cars, oil wells, apartments, education, and
`so forth. How can you decide which investment to
`make?
`
` One useful approach is to compare the rates of
`return on the different investments. For each pos-
`sibility, calculate the dollar cost of the capital good.
`Then estimate the net annual dollar receipts or
`rentals yielded by the asset. The ratio of the annual
`net rental to the dollar cost is the rate of return
`on investment, which tells you how much money
`you get back for every dollar invested, measured as
`dollars per year per dollar of investment or percent
`per year.
`
` The rate of return on investment is the annual net
`
`return (rentals less expenses) per dollar of invested
`capital. It is a pure or unitless number—percent per
`year.
`
` Of Wine, Trees, and Drills. Here are some examples
`of rates of return on investments:
`
` ● I buy a plot of land for $100,000 and sell it a year
`later for $110,000. If there are no other expenses,
`the rate of return on this investment is $10,000
`per year/$100,000, or 10 percent per year.
`
` ● I plant a pine tree with a labor cost of $100. At
`the end of 25 years, the grown tree sells for $430.
`The rate of return on this capital project is then
`330 percent per quarter-century, which, as a cal-
`culator will show you, is equivalent to a return
`of 6 percent per year. That is, $100 ⫻ (1.06) 25 ⫽
` $430.
` ● I buy a $20,000 piece of oil-drilling equipment.
`For 10 years it earns annual rentals of $30,000,
`but I also incur annual expenses of $26,000 for
`fuel, insurance, and maintenance. The $4000
`net return covers interest and repays the princi-
`pal of $20,000 over 10 years. What is the rate of
`return here? Statistical tables show that the rate
`of return is 15 percent per year.
`
` Financial Assets and Interest Rates
` For the case of fi nancial assets, we use a different
`set of terms when measuring the rate of return.
`When you buy a bond or put money in your savings
`account, the fi nancial yield on this investment is
`called the interest rate. For example, if you bought a
`1-year bond in 2008, you would have earned a yield
`of around 3 percent per year. This means that if you
`bought a $1000 bond on January 1, 2008, you would
`have $1030 on January 1, 2009.
`
` You will usually see interest rates quoted in per-
`cent per year. This is the interest that would be paid
`if the sum were borrowed (or loaned) for an entire
`year; for shorter or longer periods, the interest pay-
`ment is adjusted accordingly.
`
` THE PRESENT VALUE OF ASSETS
` Most assets will produce a stream of rentals or
`receipts over time. If you own an apartment building,
`for example, you will collect rental payments over
`the life of the building, much as the owner of a fruit
`orchard will pick fruit from the trees each year.
`
` Suppose you become weary of tending the building
`and decide to sell it. To set a fair price for the build-
`ing, you would need to determine the value today of
`the entire stream of future income. The value of that
`stream is called the present value of the capital asset.
`
` The present value is the dollar value today of a
`
`stream of future income. It is measured by calcu-
`lating how much money invested today would be
`needed, at the going interest rate, to generate the
`asset’s future stream of receipts.
`
`
`
`
`
`
`
`
`
`
`
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`

`286
`
`CHAPTER 15
`
`• CAPITAL, INTEREST, AND PROFITS
`
` Let’s start with a very simple example. Say that
`
`someone offers to sell you a bottle of wine that
`matures in exactly 1 year and can then be sold for
`exactly $11. Assuming the market interest rate is
`10 percent per year, what is the present value of the
`wine—that is, how much should you pay for the wine
`today? Pay exactly $10, because $10 invested today at
`the market interest rate of 10 percent will be worth
`$11 in 1 year. So the present value of next year’s $11
`wine is today $10.
`
` Present Value for Perpetuities
` We discuss the fi rst way of calculating present value
`by examining the case of a perpetuity, which is an
`asset like land that lasts forever and pays $ N each
`year from now to eternity. We are seeking the pres-
`ent value ( V ) if the interest rate is i percent per year,
`where the present value is the amount of money
`invested today that would yield exactly $N each year.
`This is simply
`
` V ⫽ $N ___ i
`
`where V ⫽ present value of the land ($)
`$N ⫽ perpetual annual receipts ($ per year)
`
` i ⫽ interest rate in decimal terms (e.g.,
`
`0.05, or 5⁄100 per year)
`
` This says that if the interest rate is always 5 per-
`cent per year, an asset yielding a constant stream of
`income will sell for exactly 20 (⫽ 1 ⫼ 5⁄100) times its
`annual income. In this case, what would be the pres-
`ent value of a perpetuity yielding $100 every year? At
`a 5 percent interest rate its present value would be
`$2000 (⫽ $100 ÷ 0.05).
`
` The formula for perpetuities can also be used to
`value stocks. Suppose that a share of Spring Water
`Co. is expected to pay a dividend of $1 every year
`into the indefi nite future and that the discount rate
`on stocks is 5 percent per year. Then the stock price
`should be P ⫽ $1/0.05 ⫽ $20 per share. (These num-
`bers are corrected for infl ation, so the numerator is
`“real dividends” and the denominator is a “real inter-
`est rate” or a “real discount rate,” defi ned below).
`
` General Formula for Present Value
` Having seen the simple case of the perpetuity, we
`move to the general case of the present value of an
`asset with an income stream that varies over time.
`
`The main thing to remember about present value
`is that future payments are worth less than current
`payments and they are therefore discounted relative
`to the present. Future payments are worth less than
`current payments just as distant objects look smaller
`than nearby ones. The interest rate produces a simi-
`lar shrinking of time perspective.
`
` Let’s take a fantastic example. 1 Say that some-
`one proposes to pay $100 million to your heirs in
`100 years. How much should you pay for this today?
`According to the general rule for present value, to
`fi gure out the value today of $ P payable t years from
`now, ask yourself how much must be invested today
`to grow into $ P at the end of t years. Say the interest
`rate is 6 percent per annum. Applying this each year
`to the growing amount, a principal amount of $ V
`grows in t years to $ V ⫻ (1 ⫹ 0.06) t . Hence, we need
`only invert this expression to fi nd present value:
`the present value of $ P payable t years from now is
`today $ P 兾(1 ⫹ 0.06) t . Using this formula, we deter-
`mine that the present value of $100 million paid in
`100 years is $294,723.
`
` In most cases, there are several terms in an asset’s
`stream of income. In present-value calculations, each
`dollar must stand on its own feet. First, evaluate the
`present value of each part of the stream of future
`receipts, giving due allowance for the discount-
`ing required by its payment date. Then simply add
`together all these separate present values. This sum-
`mation will give you the asset’s present value.
`
` The exact formula for present value ( V ) is the
`
`following:
`
`N2
`Nt
`N1
`
`(1 ⫹ i )2 ⫹ . . . ⫹ (1 ⫹ i )t ⫹ . . .
`_____
`________
`_______
` V ⫽
` ⫹
`
`
`
`1 ⫹ i
`In this equation, i is the one-period market inter-
`est rate (assumed constant). Further, N 1 is the net
`receipts (positive or negative) in period 1, N 2 the
`net receipts in period 2, N t the net receipts in period
` t , and so forth. Then the stream of payments ( N 1,
`N 2, . . . , N t, . . . ) will have the present value, V, given
`by the formula.
`
` For example, assume that the interest rate is
`10 percent per year and that I am to receive $1100
`
`
`
`1 Question 9 at the end of this chapter asks about the real life
`example of the present value of the real estate of Manhattan
`when it was purchased by the Dutch.
`
`
`
`
`
`
`
`
`
`
`
`Eye Therapies Exhibit 2047, 309 of 702
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`

`

`Eye Therapies Exhibit 2047, 310 of 702
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`

`288
`
`CHAPTER 15
`
`• CAPITAL, INTEREST, AND PROFITS
`
` Loans differ in their term or maturity— the length of
`
`time until they must be paid off. The shortest loans are
`overnight. Short-term securities are for periods up to
`a year. Companies often issue bonds that have maturi-
`ties of 10 to 30 years, and mortgages are up to 30 years
`in maturity. Longer-term securities generally com-
`mand a higher interest rate than do short-term ones
`because lenders are willing to sacrifi ce quick access to
`their funds only if they can increase their yield.
`
` Loans also vary in terms of risk. Some loans are
`virtually riskless, while others are highly speculative.
`Investors require that a premium be paid when they
`invest in risky ventures. The safest assets in the world
`are the securities of the U.S. government. These
`bonds are backed by the full faith, credit, and taxing
`powers of the government. Intermediate in risk are
`borrowings of creditworthy corporations, states, and
`localities. Risky investments, which bear a signifi cant
`chance of default or nonpayment, include those of
`companies close to bankruptcy, cities with shrinking
`tax bases, or countries like Argentina with large over-
`seas debts and unstable political systems.
`
` The U.S. government pays what is called the
`“riskless” interest rate; over the last two decades this
`has ranged from 0 to 15 percent per year for short-
`term bonds. Riskier securities might pay 1, 2, or even
`10 percent per year more than the riskless rate; this
`premium refl ects the amount necessary to compen-
`sate the lender for losses in case of default.
`
` Assets vary in their liquidity. An asset is said to
`be liquid if it can be converted into cash quickly and
`with little loss in value. Most marketable securities,
`including common stocks and corporate and govern-
`ment bonds, can be turned into cash quickly for close
`to their current value. Illiquid assets include unique
`assets for which no well-established market exists. For
`example, if you own the only Victorian mansion in a
`small town, you might fi nd it diffi cult to sell the asset
`quickly or at a price near its realistic market value—
`your house is an illiquid asset. Because of the higher
`risk and the diffi culty of realizing the asset values
`quickly, illiquid assets or loans require higher inter-
`est rates than do liquid, riskless ones.
`
` When these three factors (along with other con-
`siderations such as tax status and administrative
`costs) are considered, it is not surprising that we see
`so many different fi nancial assets and so many differ-
`ent interest rates. Figure 15-2 and Table 15-1 show
`the behavior of a few important interest rates over
`the last fi ve decades. In the discussion that follows,
`
`when we speak of “the interest rate,” we are generally
`referring to the interest rate on short-term govern-
`ment securities, such as the 90-day Treasury-bill rate.
`As Figure 15-2 shows, most other interest rates rise
`and fall in step with short-term interest rates.
`
` Real vs. Nominal Interest Rates
` Interest is paid in dollar terms, not in terms of houses
`or cars or goods in general. The nominal interest rate
`measures the yield in dollars per year per dollar
`invested. But dollars can become distorted yardsticks.
`The prices of houses, cars, and goods in general
`change from year to year—these days prices gener-
`ally rise due to infl ation. Put differently, the interest
`rate on dollars does not measure what a lender really
`earns in terms of goods and services. Let us say that
`you lend $100 today at 5 percent-per-year interest.
`You would get back $105 at the end of a year. But
`because prices changed over the year, you would not
`be able to obtain the same quantity of goods that you
`could have bought at the beginning of the year if you
`had $105.
`
` Clearly, we need another concept that measures
`the return on investments in terms of real goods
`and services rather than the return in terms of dol-
`lars. This alternative concept is the real interest rate,
`which measures the quantity of goods we get tomor-
`row for goods forgone today. The real interest rate
`is obtained by correcting nominal or dollar interest
`rates for the rate of infl ation.
` The nominal interest rate (sometimes also called
`
`the money interest rate ) is the interest rate on money in
`terms of money. When you read about interest rates
`in the newspaper, or examine the interest rates in
` Figure 15-2 , you are looking at nominal interest rates;
`they give the dollar return per dollar of investment.
` In contrast, the real interest rate is corrected for
`
`infl ation and is calculated as the nominal interest
`rate minus the rate of infl ation. As an example, sup-
`pose the nominal interest rate is 8 percent per year
`and the infl ation rate is 3 percent per year; we can
`calculate the real interest rate as 8 ⫺ 3 ⫽ 5 percent
`per year.
`
` To take a simple example, suppose that you live
`in an economy where the only product is bread.
`Further suppose that the price of bread in the fi rst
`period is $1 per loaf and that bread infl ation is 3 per-
`cent per year. If you lend $100 at 8 percent-per-year
`interest, you will have $108 at the end of the year.
`However, because of infl ation, next year you will get
`
`
`
`
`
`
`
`
`
`
`
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`

`

`THE MYSTERIOUS WORLD OF INTEREST RATES
`
`289
`
`Federal funds rate
`10-year Treasury bond
`Medium-grade corporate bond
`
`20
`
`16
`
`12
`
`8
`
`4
`
`Interest rates (percent per year)
`
`0
`1960
`
`1965
`
`1970
`
`1975
`
`1980
`
`1985
`Year
`FIGURE 15-2. Most Interest Rates Move Together
`This graph shows the major interest rates in the U.S. economy. The lowest rate is generally
`the federal funds rate, set by the Federal Reserve in its monetary policy. Longer-term and
`riskier interest rates are usually higher than safe and short-term rates.
`
`1990
`
`1995
`
`2000
`
`2005
`
`2010
`
`Source: Federal Reserve System, available at www.federalreserve.gov/releases/.
`
`Asset class
`
`Government securities:
` 3 month
` 10 year
`Corporate bonds:
` Safe (Aaa rated)
` Risky (Baa rated)
`Corporate equities
`Consumer loans:
` Mortgages (fi xed rate)
` Credit cards
` New-car loans
`
`Period
`
`1960–2008
`1960–2008
`
`1960–2008
`1960–2008
`1960–2008
`
`1971–2008
`1972–2008
`1972–2008
`
`Nominal rate of return
`(% per year)
`
`Real rate of return
`(% per year)
`
` 5.2
` 6.9
`
` 7.7
` 8.7
` 9.9
`
` 9.2
`16.4
`10.4
`
` 1.0
` 2.7
`
` 3.4
` 4.4
` 5.6
`
` 4.9
`11.8
` 6.0
`
`TABLE 15-1. Interest Rates on Major Financial Assets
`Safe government securities have the lowest yields. Note that consumers pay a substantial
`penalty on credit-card debt (students beware!). The real interest rates are corrected for
`infl ation. Note that Aaa bonds are the safest type of corporate security, while Baa securities
`have signifi cant risks of bankruptcy.
`
`Source: Federal Reserve Board, available at www.federalreserve.gov/releases/, and Department of Commerce.
`
`
`
`
`
`
`
`
`
`
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`BASIC CAPITAL THEORY
`
`291
`
`$1000 bond bought in 2000 would be valued at $1120 in
`June 2003. If the Treasury made an interest payment in June
`2003, it would be 4¼ percent of $1120, instead of 4¼ per-
`cent of $1000 as would be the case for a standard bond.
`Let’s further suppose that infl ation averaged 3 percent
`per year from 2000 to 2010. This means that the princi-
`pal value of the bond upon redemption would be $1343.92
`[⫽ $1000 ⫻ (1.3) 10 ], instead of the $1000 for a conven-
`tional bond.
`
` As long as people expect that there will be infl ation in
`the coming years, the interest rate on TIPS will be less than
`that on standard Treasury bonds. For example, in April 2008,
`standard 10-year Treasury bonds had a nominal yield of
`3.6 percent, while 10-year TIPS had a real yield of 1.2 percent.
`This indicates that the average investor expected 10-year
`infl ation to average 3.6 ⫺ 1.2 ⫽ 2.4 percent per year.
`
` The difference between nominal and real interest rates
`on long-term bonds is illustrated in Figure 15-3 . The upper
`line shows the nominal interest rate, while the long lower
`line shows the calculated real interest rate. In addition,
`the short green segment that begins in 2003 shows the
`real interest rate on TIPS. This fi gure shows that the rise
`in nominal interest rates from 1960 to 1980 was purely
`illusory, for nominal interest rates were just ke