Table of Contents:
Why do Interest rates matter?
Think about the Economic Crisis in Europe. For countries, the interest rates matter. For their citizens, interest rates really matter. Imagine...
- "As lenders have fled from weaker credits, the interest rate on German Bunds has fallen to 1.3 per cent, against 5.8 per cent in Italy and 6.2 per cent in Spain. With flat nominal gross domestic products, countries with high interest rates are at risk of falling into a debt trap. " Martin Wolf
What is "Interest"?
Definition: An interest rate is the cost of borrowing money.
- in essence, interest is a payment for the use of cash-- it is like a "rent" charged for the use of an asset (you pay a rent to use the house asset of someone else, just as you pay a rent to use their cash).
- deposits pay interest because they are really like a loan from the individual to the bank
- money deposited in a bank is an asset, because you could have spent it, but decided to put in the bank instead.
- So, think of it like this...when you deposit dollars in a bank, that is the same as "buying" deposits in exchange for an interest that the bank agrees to pay you.
- future value -- key concept - $10 today is worth more than $10 a year from now (because you could put it in the bank and earn interest)
- Interest is alternatively seen as the amount of a Currency that an individual can earn for lending a unit of that currency for one year.
Note: the amount borrowed is called the "principal"
At any given time, there are a number of interest rates available in the economy. Interest rates very across the size, risk, duration, and liquidity of an investment. The interest rates for various durations of investments (short- to long-term) are called the yield curve.
simple interest
- ignores interest on previously earned interest
compound interest
"Money makes money and the money that money makes makes more money"- Benjamin Franklin
- interest is added to principal each period
-the longer lasting the loan, the more important interest on interest becomes
Stated Annual Interest Rate (SAIR)
is the rate of interest without consideration of compounding. If a bank says 10% interest, compounded semi-annually then the actual "Effective Annual Interest Rate (EAIR)" is = (1 + 0.10/2)^2 = 1.1025 = 10.25% effective interest per year. So, 10% compounded semi-annually is the same as 10.25% compounded annually.
EAIR (effective annual interest rate)
Calculate the Effective Rate as follows:
EAIR: (1 + r/m)^m - 1
example: if you invest $2000 at a stated interest rate of 10% per year, compounded semi-annually for 7 years, the value at the end of 7 years would be
= $2000 * (1 + 0.10/2)^(2*7)
= $2000 * (1.05)^14
= $2000 * (1.980)
= $3,959.60
Continuous Compounding
Often quoted by banks.
FV = PV x e^(rt)
where PV = current investment, e = 2.718 (constant), and r=stated annual interest rate, and t = number of years
Calculator:
see tab "future value" Spreadsheet_Bond_Valuation.xls
How interest rates are set
Interest rates rise or fall largely as a result of the amount of money in circulation at any given time. The Federal Reserve Bank of the United States affects both short term and long term interest rates by manipulating money supply through open market operations or changing reserve requirements for banks. The former involves purchasing large volumes of government securities, in order to increase money supply (driving interest rates down) or selling large quantities of government securities in order to decrease money supply (driving interest rates up). The Fed can also raise the reserve requirement for banks, increasing the amount that banks have to hold against loans, and decreasing the amount that they can loan to the public. Two important factors affecting the Fed's decision to raise rates are inflation and the overall health of the economy. When inflation is too high or increasing too rapidly, the Fed may raise rates in order to slow the economy. Conversely when the economy is doing poorly the Fed may cut rates in order to promote stronger growth.
Industries most affected by changes in interest
Among the many industries affected by fluctuations in interest rates, real estate and banking are perhaps the most directly impacted. When interest rates increase, borrowing becomes more expensive, dampening consumer demand for mortgages and other loan products and negatively affecting residential real estate prices.
Relation between interest rates and Inflation
inflation targeting
More Info
Interest rates
The interest rate is the price paid for borrowing money. We usually calculate interest as percent per year on the amount of borrowed founds. There are many interest rates depending upon the maturity, risk, tax status, and other attributes of the borrower.
The present value of an asset is the dollar value today of the time stream of income generated by that asset. It is measured by calculating how much money invested today would be needed, at the going interest rate, to generate the asset’s future stream of receipts.
Relationship between interest rates and the level of investment
Investment is often modeled as a function of income and interest rates, given by the relation I = F(Y, i). An increase in income will encourage higher investment, whereas a higher interest rate may discourage investment as it becomes costlier to borrow money. Even if a firm chooses to use its own funds in an investment, the interest rate represents an opportunity cost of investing those funds rather than loaning them out for interest.
Demand for money
Money Functions are: Medium of Exchange, Unit of account, and Store of Value.
The Costs of holding money is the interest foregone from not holding other assets.
Sources of Demand:
1. Transactions Demand for Money. Other things constant, as interest rise, the quantity of money demand declines.
2. Asset Demand.
Movements of the interest rate
Nominal interest rate (NIR)
Also called the money interest rate, is the interest rate on money in terms of money. NIR is the dollar return per dollar of investment.
Real interest rate (RIR)
Real interest is corrected from inflation, and is calculated based on nominal interest rate mines the rate of inflation.
RIR = NIR – Inflation
During inflationary periods, we must use real interest rates, not nominal or money interest rates, to calculate the yield on investment in terms of goods earned per year on goods invested. The real interest rate is approximately equal to the nominal interest rate minus the rate of inflation.
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