Interest rate

From Traderpedia

The "rental" price of money.

When a resource or asset is borrowed, the borrower pays interest to the lender for the use of it. The interest rate is the price paid for the use of money for a period of time. One type of interest rate is the yield on a bond, another is the amount (expressed as a percentage of the total sum lent) that a bank would pay someone who deposits money with them.

When money is loaned the lender defers consumption (or other use of the money) for a specific period of time. The lender does this in exchange for an expected increase in future income. The expected increase in interest payments (relative to the amount loaned) is the nominal interest rate, and can be defined as the face value of money received by the lender, or paid by the borrower.


[edit] Example

[edit] Nominal interest rate

For example, suppose a person deposits £100 with a bank for 1 year and receives interest payments totalling £10. In this case, the nominal interest rate is 10% per annum. This is also known as the annual percentage return (APR).

[edit] Real interest rate

The real interest rate, which measures the purchasing power of interest receipts, is calculated by adjusting the actual rate received (the nominal interest rate) to take inflation into account.

A first approximation for the real interest rate for a one-year loan is:

ir = inpe


in = nominal interest rate
ir = real interest rate
pe = expected or projected inflation over the year.

After the fact, there is the realized or ex post real interest rate:

ir = inp

where p = the actual inflation rate over the year.

Thus, if the (expected) inflation rate is 5% and the nominal interest rate is 7%, the (expected) real interest rate is 2%.

If financial markets have adjusted for the effects of expected inflation and the real interest rate is given, then the nominal rate approximately equals:

ir + pe

Thus, if the real interest rate is 3% and the inflation rate equals 5%, the nominal interest rate = 8%. The theory of rational expectations is sometimes applied to say that this equation applies in most cases. Most economists would agree that it applies over several years, as financial markets adjust: higher inflation leads to higher nominal rates, all else being equal.

[edit] See also