Real Rate

Even in the absence of inflation,

even assets without risk
(say a guaranteed bank deposit)
give a return (call it the “interest rate”)

Why?

What does this “real rate” depend upon?

Professor Sagarika Mishra, XSRM, XUB 1

 Computing Real Rate
t=0 Real Rate t=1
Lend Get back
25 Apples = (26-25) / 25 26 Apples

= 4.00%
People prefer
current consumption to future consumption
and, therefore,
demand a compensation for postponing consumption.
THAT REFLECTS IN THE REAL RATE (OF 4% HERE)
Professor Sagarika Mishra, XSRM, XUB 2
 Nominal Rate
Rs 0.80 Price Per Apple Rs 0.80

t=0 t=1
Lend Get back
Rs 20 Nominal Rate = ??

20.80 – 20.00
------------------
20.00
This buys Should be able
25 apples = 4.00% to buy 26 apples
=> Need
Rs 20.80 (=Rs 0.80 x 26)
Professor Sagarika Mishra, XSRM, XUB 3
Inflation and Nominal Rate
Rs 0.80 Price Per Apple Rs 0.83

t=0 t=1
Lend Get back
Rs 20 Nominal Rate = ??

21.58 – 20.00
------------------
20.00
This buys Should be able
25 apples = 7.90% to buy 26 apples
=> Rs 0.83 x 26
= Rs 21.58
Professor Sagarika Mishra, XSRM, XUB 4
Nominal Rate: Fisher Effect
Nominal Rate =

[(1+Real Rate) x (1+ Expected Inflation)] – 1*

Using notation, R = [ (1+r) (1+h) – 1]

Here, R = [(1+4.00%) *( 1+3.75%)] – 1 = 7.90%

Expected Inflation (in Apple Price)= (0.83 – 0.80) / 0.80 = 3.75%

[*Nominal Rate Approximately Equals Real Rate + Inflation Premium]

Professor Sagarika Mishra, XSRM, XUB 5

How is interest Rate decided by the banks?
Banks’ deposit interest rates depend upon the growth in the economy which indicates real
rate and inflation expectations.
Lending interest rates need to be appropriate to the borrowers depending on their risk
profile and at the same time they should also be competitive for banks whereby they earn
reasonable risk adjusted return to remain profitable. Earlier we had base rate system
Base Rate=a+b+c+d
• A = cost of deposits which is can be lent out
• B= Unallocatable overheads (salary of the employee, rent, operational expenses)
• C= Cost of Cary (CRR +SLR)
• D= Bank’s Profit
Actual lending rate is higher than base rate which includes the loan specific aspects like risk
and all…

Professor Sagarika Mishra, XSRM, XUB 6

Lending rate as per RBI (CASA- current to saving account ratio, lower the value,
lower is the cost of funds.

• cas

Professor Sagarika Mishra, XSRM, XUB 7

MCLR (marginal cost of funds based lending
rate)
• Before April 2016, All banks were declaring their Base rate. Then after it has
changed to MCLR Following are the main components of MCLR.
Here
Costs that the bank is incurring to get funds (means deposit) is calculated on a
marginal basis
The marginal costs include Repo rate; whereas this was not included under the base
rate.
Many other interest rates usually incurred by banks when mobilizing funds also to
be carefully considered by banks when calculating the costs.
The MCLR should be revised monthly.
A tenor premium or higher interest rate for long term loans should be included
Professor Sagarika Mishra, XSRM, XUB 8
A look at some country’s interest rate, growth and inflation

CPI CENTRAL BANK COMMERCIAL BANK

COUNTRY INFLATION GROWTH RATE LENDING RATE

INDIA 3.35 7.3 6.25 10.01

JAPAN 0.1 0.6 -0.1 1.5

USA 1.69 2.6 1 3.3

CHINA 2.3 6.9 4.35 6

Professor Sagarika Mishra, XSRM, XUB 9