1. Interest rate, Nominal Interest Rate & Real Interest Rate.
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2. Interest rate
Interest rate: the amount charged, expressed as a percentage of principle. It is typically noted on an annual basis, know as the annual percentage rate (APR).
Nominal interest rate (i): is the rate of interest that is reported on loan documents or investment accounts that are not adjusted for inflation.
Real interest rate (r): it is an interest rate that has been adjusted to remove the effects of inflation.
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3. Fisher Effect
Real interest rate (r) = nominal interest rate (i) – inflation (π) (expected OR actual) i = r + π Fisher Effect Question: If you have been offered by a bank 5% interest rate for one year for principal of £100 what is your money at the end of year? How much is your profit?
It shows that the nominal interest can change for two reasons: because the real interest rate changes or because the inflation rate changes.
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4. Simple and Compound Interest Rate
Simple interest rate (%): A quick method of calculating the interest charge on a loan. Simple interest is determined by multiplying the interest rate by the principal by the number of periods.
Simple interest = P * I * N
Compound interest rate (%): Compound interest rate is calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. (interest on interest)…
Compound interest = P [(1 + i)n – 1]
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5. Simple and Compound Interest Rate
Example 1: if person A deposit £800,000 into a bank, with a simple interest rate of 6% for 3 years. Calculate the total amount of person A and the profit after 3 years?
Answers: (total amount = £944,000), (profit = £144,000)
Example 2: if person A deposit £800,000 into a bank, with a compound interest rate of 6% for 3 years. Calculate the total amount of person A and the profit after 3 years?
Answers: (total amount = £952,812.8), (profit = £152,812.8)
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6. How does interest rate affect Consumption
Many consumer goods are bought on credit, so an increase in interest rates discourages this as the price of borrowing going up. So AD decreases.
Equally AD will increase if interest rates fall and borrowing is now more attractive
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7. How does interest rate affect Investment
Much of the investment is financed through borrowing so the same principle as consumption applies here.
LOW INTEREST RATE = HIGHER INVESTMENT
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