Copyright 2014 by Diane Scott Docking

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Interest Rates Theories






. . . Wasnt it Ben Franklin who said
that????
A fool and his
Money are soon
Partying!!!!
Copyright 2014 by Diane Scott Docking
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Learning Objectives
Know how inflation, expectations, and risk
combine to determine interest rates
The distinction between real and nominal
interest rates
The Fisher Effect
Copyright 2014 by Diane Scott Docking
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Interest Rates Defined
Interest rates - are a measure of the
price paid by a borrower (or
debtor) to a lender (or creditor)
for the use of resources during some
time interval.

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Distinction Between Real
and Nominal Interest Rates
Inflation and Real Rates Versus
Nominal Rates
Inflation: measures how the purchasing
power of a given amount of currency
declines due to growing prices
Nominal interest rates: indicates the rate
at which your money will grow if invested
for a certain period (the stated rate)
Real interest rate: the rate of growth of
your purchasing power, after adjusting for
inflation
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Distinction Between Real
and Nominal Interest Rates - Simplified
Real interest rate
1. Interest rate that is adjusted for expected
changes in the price level
i
r
i
e
2. Real interest rate more accurately reflects true
cost of borrowing
3. When the real rate is low, there are greater
incentives to borrow and less to lend
n r
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Example: Distinction Between Real
and Nominal Interest Rates - Simplified
If i = 5% and
e
= 0% then
i
r
5%0% 5%
i
r
10%20% 10%
If i = 10% and
e
= 20% then
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Fisher Effect
The exact Fisher equation is:

inflation. of rate annual expected the
interest, of rate real the
interest, of rate nominal observed the
where
1 1 1

e
r
i
i
e
i
r
i
Copyright 2014 by Diane Scott Docking 9
Fisher Effect, cont.
From the Fisher equation, we derive the nominal
(contract) rate:


We see that a lender gets compensated for:
rental of purchasing power
anticipated loss of purchasing power on the principal
anticipated loss of purchasing power on the interest



e
i
r
e
i
r
i
Copyright 2014 by Diane Scott Docking
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Fisher Effect: Example
1-year $1000 loan
Parties agree on 3% rental rate for money and
5% expected rate of inflation.

Items to pay Calculation Amount
Principal $1,000.00
Rent on money $1,000 x 3% 30.00
PP loss on principal $1,000 x 5% 50.00
PP loss on interest $1,000 x 3% x 5% 1.50
Total Compensation $1,081.50

i = .03+.05+(.03x.05) = .08+.0015=.0815=8.15%
P+i$=$1,000x(1.0815)=$1,081.50
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Simplified Fisher Equation
The third term in the Fisher equation is
negligible, so it is commonly dropped.
The resulting equation is

e
i
r
i
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Example:
Calculating the Real Interest Rate
In the year 2000, short-term U.S. government
bond rates were about 5.8% and the rate of
inflation was about 3.4%. In 2003, interest
rates were about 1% and inflation was about
1.9%. What was the real interest rate in 2000
and 2003?
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Example:
Calculating the Real Interest Rate
Solution:
Thus, the real interest rate in 2000 was:
nominal rate inflation rate
real rate
1 inflation rate

(5.8% 3.4%) / (1.034) 2.32%

In 2003, the real interest rate was:
(1% 1.9%) / (1.019) 0.88%.