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Real interest rate = Nominal rate - Expected inflation

In the above equation, in a quarterly data-set, which expected inflation shall be used? next quarter (q+1) or the same quarter of next year (q+4)? and why?

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It is the expected inflation rate over the life of the instrument. So if it is a 10-year bond, it is expected inflation over the next 10 years.

If you use future values of the price index to determine “expected” inflation, you are assuming bond investors can predict the future perfectly. Based on my experience, that assumption is implausible. It could be justified, but one would really need to be careful about how the data are interpreted.

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  • $\begingroup$ Thank you Brian for your answer. I am asking in the context of a macroeconomic model, not the bond market. In this model, different economic agents (i.e. households, firms, etc.) set their expectations to be forward-looking. Accordingly, the question remains which expected inflation shall be used? next quarter (q+1) or the same quarter of next year (q+4)? and why? $\endgroup$ – Ramy Oraby Jun 6 at 12:40
  • $\begingroup$ Whether or not they are bond investors, the logic is the same. If you want to discuss a real rate, you need to match the terms. If you are not interested in a real rate, and just inflation expectations, you need to ask why the agent is interested in inflation? I am unconcerned about inflation over the next three months if I am thinking about my retirement plans. $\endgroup$ – Brian Romanchuk Jun 6 at 16:13
  • $\begingroup$ Yes, this is what i am asking. It is a specific question, rather than a general problem. In a macro-model (QPM or DSGE), what is the difference between using next quarter (q+1) or the same quarter of next year (q+4) to reflect inflation expectations? $\endgroup$ – Ramy Oraby Jun 8 at 10:07

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