Nominal vs Real Interest Rates

7 Key excerpts on "Nominal vs Real Interest Rates"

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  eBook - ePub

  Money and Banking

  An International Text

  • Robert Eyler(Author)
  • 2009(Publication Date)
  • Routledge

    (Publisher)

  Interest rates come in many forms, all with the same basic set-up. An interest rate includes measures of risk, both general and very specific. When you borrow money, the rate at which you borrow is the nominal rate. This rate is the stated interest cost or return of a financial investment. There is also a real rate, but what separates the two? The difference between nominal and real variables in economics has to do initially with inflation, or purchasing power erosion, and other risks. In its most basic form, a nominal interest rate has the following equation:

  R = r + P

  (2.1)

  where R is a nominal rate, r is the associated real rate and P is the expected inflation rate. Equation 2.1 assumes the only risk to be inflation. The best way to think of the real rate of interest is what the lender wants to receive as revenue, less the calculated risks. The nominal rate is the sum of the real rate and the “expected” inflation rate, which is a calculated guess and not the actual inflation rate. When a lender provides a loan, the lender must make conjectures concerning what the risk of future inflation may be. Unless the interest rate is allowed to adjust with new inflation information, the lender bears that risk directly; when inflation rises without the nominal rate changing, the real value of her loan gets smaller. Both the borrower and lender make decisions based on their individual assessment of the real rate of interest. Even though the borrower writes a check every month to the credit card company based on a nominal rate, the lender is seeking protection of the real rate as the driving force behind providing credit. If all the expected risks play themselves out as predicted, the borrower and lender pay and receive the real rate respectively.

  We will discuss later the difference between fixed and variable rates of interest, but keep in mind that few assets, real or financial, can circumvent the risk of inflation. Inflation is also a representation of time in financial markets, specifically eroding nominal income and wealth.

  Defining interest rates

  The cost of borrowing

  This is the classic role we think of interest rates playing in finance, an explicit cost of consuming beyond one’s income or wealth by choice. As a corollary, it is also the opportunity cost of consuming, regardless of the entity being a net consumer or not. A net consumer is a household that both consumes and saves, but consumes more than its income in net. If one consumes anything, there is lost interest revenue from saving the resources otherwise; however, financial leverage may be a decision because the cost of debt is less than the return to savings. Households are willing to bear this cost, however, at some level because of necessity and because of satisfaction or utility otherwise, an issue discussed in more detail in Chapter 9

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  eBook - PDF

  Financial Institutions, Markets, and Money

  • David S. Kidwell, David W. Blackwell, David A. Whidbee, Richard W. Sias(Authors)
  • 2016(Publication Date)
  • Wiley

    (Publisher)

  The interest rate is the price of “renting” an amount of money over a given period of time. Interest rates are similar to other prices in the economy in that they allocate funds bet- ween SSUs and DSUs. 2 Define the concept of the real interest rate and explain what causes the real interest rate to rise and fall. The real rate of interest is the fundamental long‐run interest rate in the economy. It is the market equilibrium interest rate at which desired lending by savers equals desired borrowing by producers. It is the rate of interest that prevails under the assumption that there is no inflation in the economy. 3 Explain how inflation affects interest rates. To pro- tect borrowers and lenders from unwarranted transfers in purchasing power, the nominal (or stated) interest rate on a loan equals the real rate of interest plus compensation for changes in the purchasing power of money caused by price‐level changes. This relationship is shown in the Fisher equation, which states that the nominal interest rate equals the real rate of interest plus the expected inflation rate. 4 Calculate the realized real rate of return on an investment. The return from a loan stated in terms of purchasing power of money is the realized real rate of return, which equals the nominal interest rate minus the actual rate of inflation. The realized real rate of return can be positive, zero, or negative, depending on how differ- ent actual inflation is from expected inflation. 5 Explain how economists and financial decision makers forecast interest rates. Investors and financial institutions have a keen interest in forecasting the move- ments of interest rates because of the potential impact on their wealth. Interest rate forecasting models use expected economic activity and inflation expectations to predict interest rates.

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  eBook - PDF

  A Concise Guide to Macroeconomics, Second Edition

  What Managers, Executives, and Students Need to Know

  • David Moss(Author)
  • 2014(Publication Date)
  • Harvard Business Review Press

    (Publisher)

  This formula is derived from the following growth equation: Final value = Starting value × (1 + r) (number of years) , where r is the average annual growth rate of the variable in question. Understanding the Macro Economy 44 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 Simply put, the real interest rate represents the effective rate of interest on a loan after controlling for inflation. Nominal interest rates rise with inflation because creditors care about their command over real output, not their command over money per se. Imagine, for example, that a dairy farmer (let’s call him Bill) agreed to lend his neighbor (Tom) 10 milk cows for an entire season on the condition that Tom would return all 10 plus one more cow at the end of the year. This would constitute a one- year loan at a 10 percent rate of interest. Now suppose that after repaying the loan at the end of the year (by delivering 11 cows to Bill), Tom wanted to do the same thing again—that is, he wanted to borrow 10 cows from Bill for one year at a 10 percent rate of interest. The only difference was that this time he proposed repay- ing the loan in money rather than in cows. Since a cow cost $1,000 at the time of the agreement, Tom promised that he would pay Bill $11,000 at the end of the year. Bill thought this sounded fine and agreed to the deal. Unfortunately for Bill, however, the price of a cow increased by 10 percent that year, rising from $1,000 to $1,100. As a result, when Tom made good on the loan by paying Bill $11,000 at the end of the year, Bill was only able to buy 10 cows, not 11, with that sum of money. It was as if Bill had lent his original 10 cows at no interest at all! Economists would say that under the second arrangement, the nominal interest rate was 10 percent but that the real interest rate was zero.

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  eBook - PDF

  Advanced Engineering Economics

  • Chan S. Park, Gunter P. Sharp(Authors)
  • 2021(Publication Date)
  • Wiley

    (Publisher)

  Other names are real dollars, deflated dollars, and today’s dollars. • Market interest rate (i) represents the opportunity to earn as reflected by the actual rates of interest available in the financial market. The interest rates used in previous sections are actually market interest rates. (The designation i is used consistently throughout this book to represent interest rates available in the marketplace.) When the rate of inflation increases, there is a corresponding upward movement in market interest rates. Thus, the market interest rates include the effects of both the earning power and the purchasing power of money. Other names are combined interest rate, nominal interest rate, mini- mum attractive rate of return, and inflation-adjusted discount rate. • Inflation-free interest rate (i ′ ) represents the earning power of money isolated from the effects of inflation. This interest rate is not quoted by financial institutions and other investors and is therefore not generally known to the public. This rate can be computed, however, if the market interest rate and inflation rate are known. Naturally, if there is no inflation in an economy, i and i ′ should be identical. Other names are real interest rate, true interest rate, and constant-dollar interest rate. • General inflation rate (f ) represents the average annual percentage of increase in prices of goods and services based on CPI. The market inflation rate is expected to respond to this general inflation rate. Escalation rate (f i ) represents a specific inflation rate applicable to a specific segment of the economy. It is sometimes used in contracts. It is important to recognize that there is a relationship between inflation and interest rate. For example, the historical rate on AAA bonds is about 2.5% to 3% above the general inflation rate as measured by the CPI [1]. In addition, the rate of return (ROR) required by well-managed companies on their investments must be at some level above the inflation rate.

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  Available until 5 Dec |Learn more

  Engineering Economics for Aviation and Aerospace

  • Bijan Vasigh, Javad Gorjidooz(Authors)
  • 2016(Publication Date)
  • Routledge

    (Publisher)

  4 Nominal and Effective Interest Rates

  In regards to the price of commodities, the rise of wages operates as simple interest does, the rise of profit operates like compound interest. Our merchants and masters complain much of the bad effects of high wages in raising the price and lessening the sale of goods. They say nothing concerning the bad effects of high profits. They are silent with regard to the pernicious effects of their own gains. They complain only of those of other people.

  Adam Smith

  In the past two chapters, the interest rates were compounded annually. The majority of investment projects evaluated by professional engineers, and almost all financial institutions, use interest rates that are compounded more frequently than once a year. Common interest compounding time frames are daily, monthly, semi-annually, annually, and continuously compounding. More frequent compounding means that the investors receive a higher return, whereas less frequent compounding results in receiving a lower return. For instance, most credit card companies compound interest daily; that results in effective annual rates that exceed the annual stated interest rates.

  The focus of this chapter is to enable practitioners and professional engineers to make a distinction between nominal and effective interest rates as applied to the engineering projects and financial activities of aviation and aerospace companies. Nominal and effective interest rates are common in business practices, financial management, and engineering economy. This chapter presents the process of converting nominal interest rates to effective interest rates.

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  eBook - PDF

  International Macroeconomics

  • Harms, Philipp(Authors)
  • 2016(Publication Date)
  • Mohr Siebeck

    (Publisher)

  Note that both real interest rates refer to their domestic economy’s goods bundles, i.e. they are effective (consumption-based) interest rates as introduced by equation (4.48) of Chapter IV. The real exchange rate enters the picture since a com-parison of real interest rates across countries requires considering how the value of the foreign goods bundle (in terms of the domestic goods bundle) evolves over time. In earlier chapters, we have met some special cases of this condition: if purchasing power parity prevails at all points in time, the real exchange rate is constant, and expected real interest rates have to be identical. In case of perfect foresight, this not only applies to expected, but also to actual real interest rates. In fact, the concept of a “world” real interest rate prevailing on all financial markets, on which most of our analysis in Chapter III was based, rested on the joint assumptions of perfect capital mobility, perfect foresight, and purchasing power parity. If we drop the assumption of pur-chasing power parity, the above equation requires that anticipated changes of the real exchange rate are mirrored by differences of real interest rates. VIII.3.4 Determining the Nominal Exchange Rate under Perfect Capital Mobility: A Simple Diagram If the exchange rate is fixed and market participants do not expect any change of E , i.e. t e t E E 1 the uncovered interest parity condition has an important implication: with perfect capital mobility, F t H t i i has to prevail, i.e. nominal interest rates must be identical for the two countries considered. We will return to the policy consequences of this insight in Chapter X. 338 VIII The Nominal Exchange Rate By contrast, a flexible exchange rate adjusts to changes in market constellations. To understand the forces at play, we illustrate the log-linear version of the un-covered interest rate parity condition from (8.6) in Figure 8.8.

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  eBook - ePub

  The Macroeconomic Environment of Business

  Core Concepts and Curious Connections

  • Maurice D Levi(Author)
  • 2014(Publication Date)
  • WSPC

    (Publisher)

  CHAPTER 7 INTEREST RATES

  “Gentlemen prefer bonds”

  Andrew Mellon

  Key Concepts: Interest rates and the supply of loanable funds; interest rates and the demand for loanable funds; the equilibrium interest rate; the market versus equilibrium interest rate; monetary policy and interest rates; real growth and interest rates; anticipated inflation and interest rates; real versus nominal interest rates; fiscal deficits, crowding-out and interest rates; international capital flows and interest rates.

  THE INTEREST IN INTEREST RATES

  Interest rates have a substantial effect on borrowing and spending decisions of businesses and consumers, and thereby on employment, GDP, and other measures of macroeconomic activity. For example, as we shall see, interest rates influence the willingness of businesses to invest in new plant and equipment, and in turn, the current and future size of the GDP.

  At the same time that interest rates affect the economy, the economy affects interest rates. This occurs as a result of the effects that national income, inflation and confidence about the future have on the willingness of consumers and businesses to borrow and invest, and hence on the price of borrowing, which is the interest rate. With the direction of flow being in both directions, from interest rates to the economy and from the economy to interest rates, in order to explain interest rates we need a theory that captures this two-way flow of influence. Such a theory is the loanable funds theory. While there are numerous other theories of interest rates, the loanable funds theory embraces many aspects of these other theories, and therefore serves as an ideal window onto the world of interest rates.

  LOANABLE FUNDS THEORY OF INTEREST

  According to the loanable funds theory, interest rates are determined by the supply of and demand for loanable funds, which can be thought of as monies that can be lent and borrowed. Therefore, in order to explain this theory, we must begin by considering loanable funds supply and demand.

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