LESSON 7 – INTEREST RATES

Main Lecture:

3. Real vs. Nominal Interest Rates

We learned above that the third and most important reason why lenders demand interest is that inflation tends to decay the real value of loans over time. For example, let’s say a loan is made for \$10,000, inflation is 5%, and the loan is paid back after one year. When the loan is made, it can purchase \$10,000 worth of goods, such as a compact car. After a year of inflation at 5%, the same compact car costs \$10,500. At the same time, one year later, the \$10,000 loan is repaid in full. Unfortunately, due to inflation, the real value, or purchasing power, of the money when the loan is repaid is \$500 less than when it was made.

By charging an interest rate at least equal to the rate of inflation, this problem is corrected. For example, say a loan is made for \$10,000 at 5% interest, inflation is 5%, and the loan is paid back after one year. When the loan is made, it can purchase \$10,000 worth of goods, such as a compact car (again). After a year of inflation at 5%, the same compact car costs \$10,500. At the same time, one year later, the loan is repaid in full plus interest, totaling \$10,500. In this case, the effects of inflation and the interest rate counteract each other so that the real value of the money stays the same even though the nominal value of the money increases by \$500.

Two different interest rates are used in the discussion of loans. The nominal interest rate is the interest rate reported when a loan is made. This rate does not take into account the effects of inflation. The real interest rate is not usually reported when a loan is made. This rate takes into account the effects of inflation on the purchasing power of money repaid from a loan.

Interest rates directly affect our way of spending. When the interest rates are higher, we tend to save more. Spending also decreases because people borrow less, due to higher interest rates. This way, they have less money to spend and so the net effect is a decrease in spending. Incase of lower interest rates, its quite the opposite. People will be encouraged to borrow more and subsequently spend more. Therefore the spending in that particular economy will increase. ( You can also evaluate that an increase in spending means that more economic activity will take place along with an increase circulation of money which will trigger an economic growth. Thus lowering interest rates can have positive effects)

Q1. Why do lenders require borrowers to pay interest?

ANS. Lenders require borrowers to pay interest for three reasons. First, when a person lends money, he or she is unable to use this money to fund purchases. Second, the borrower may default on the loan. Third, while the borrower has the money, inflation tends to reduce the real value, or purchasing power, of the loan.

Q2. How much would be due on a \$20,000 loan at 6% interest after 3 years?

ANS. To calculate the value of a loan, add one to the interest rate, raise it to the number of years for the loan, and multiply it by the loan amount. So, the equation becomes \$20,000 * (1.06 ^ 3) = \$23820.32 total due after 3 years.

Q3. How does the nominal interest rate differ from the real interest rate?

ANS. The nominal interest rate does not take the effects of inflation into account, but the real interest rate does.