Chapter 5 - Real & Money Interest Rates

Money Interest rate

The rate of interest which will have been earned so as to produce the total amount of cash in hand at the end of the period of accumulation.

Inflation

Measure of the increase in the cost of goods and services.

Purchasing Power

The goods that a given amount of money can buy.

When inflation occurs, we can buy less goods with the same amount of money.

Real Interest rate

The rate of Interest which will have been earned so as to produce the total amount of cash in hand at the end of the period of accumulation reduced for the effects of inflation.

Two factors determine the usefulness or real or money interest:

• The purpose to which the rate will be put

• Whether the underlying data have or have not already been adjusted for inflation

If the interest rate has been adjusted for inflation…

It would not be appropriate to allow for inflation again and hence a money rate would be assumed.

Real vs Money Interest rate

Real rates of interest allow for future inflation.

Money rates of interest ignore the effects of inflation.

In periods of positive inflation:

Real rate of interest is lower than the money rate of interest

In periods of negative inflation:

Real rate of interest is higher than the money rate of interest

In periods of zero inflation:

The real rate of interest is equal to the money rate of interest.