Lecture 4
Understanding Interest Rates
Why Interest Rates are Important?
• Interest rates are the most closely watched
variable of the economy
– It has direct impact on the lives of citizens and
firms
– It matters when you buy a house, or invest your
money in stock market or put your money in a
bank
– It also impacts on decision of investing in a new
project
What are the interest rates?
• Interest rate is the cost of borrowing or the
price paid for the rental of funds
• The Nominal Interest Rate is the interest rate
that is written down in a mortgage contract,
on the face of a bond as a coupon, or on
another debt instrument such as a fixed-term
loan
• The Real Interest Rate is the inflation-adjusted
nominal interest rate: ir = i-µe
How real interest rates affect lending
and borrowing
• Suppose expected inflation rate is 3% and nominal
interest rate is 5%, your real interest rate is 2% which
means you have earned 2% in terms of goods and
services,
• Means that you will receive 5% more rupees and pay
2% more for goods, the result is that you will be able
to buy 2% more goods
• There will be incentive for investors to lend when real
interest rates are positive
• When real interest rate is lower than inflation,
investors will hesitate to lend and will prefer to borrow
Distinction between interest rates and
return
• Should investors be concerned about interest
rates or rate of returns?
• Rate of return is the payment to the owner of
a security plus the change in its value,
expressed as fraction of its purchase price
Why rate of return differs from
interest rates
• A rise in interest rate is associated with a fall in
bond price, resulting in capital loss which makes
the rate of return lower than interest rates
• The more distant a bond maturity, the greater
the size of price change associated with an
interest rate change
• Even though a bond has a substantial initial
interest rate, its return can turn out to be
negative if interest rates rise