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Understanding Interest Rates

The document discusses interest rates, explaining what they are, how real interest rates affect lending and borrowing, and the distinction between interest rates and rates of return. Interest rates are the most closely watched economic variable and impact decisions like home buying, investing, and new projects. The real interest rate is the nominal rate adjusted for inflation. Real positive rates incentivize lending while lower real rates than inflation discourage it. Return also incorporates changes in security prices, so it can differ from stated interest rates.

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Abdul Rafay
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0% found this document useful (0 votes)
28 views6 pages

Understanding Interest Rates

The document discusses interest rates, explaining what they are, how real interest rates affect lending and borrowing, and the distinction between interest rates and rates of return. Interest rates are the most closely watched economic variable and impact decisions like home buying, investing, and new projects. The real interest rate is the nominal rate adjusted for inflation. Real positive rates incentivize lending while lower real rates than inflation discourage it. Return also incorporates changes in security prices, so it can differ from stated interest rates.

Uploaded by

Abdul Rafay
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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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

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