Composition of Interest Rates

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Composition of interest rates In economics, interest is considered the price of money, therefore, it is also subject to distortions due to inflation. The nominal interest rate, which refers to the price before adjustment to inflation, is the one visible to the consumer (i.e., the interest tagged in a loan contract, credit card statement, etc). Nominal interest is composed by the real interest rate plus inflation, among other factors. A simple formula for the nominal interest is: i = r + π Where i is the nominal interest, r is the real interest and π is inflation. This formula attempts to measure the value of the interest in units of stable purchasing power. However, if this statement was true, it would imply at least two…show more content…
The risks of an individual debt may have a large standard deviation of possibilities. The lender may want to cover his maximum risk. But lenders with portfolios of debt can lower the risk premium to cover just the most probable outcome. Deferred consumption: Charging interest equal only to inflation will leave the lender with the same purchasing power, but he would prefer his own consumption NOW rather than later. There will be an interest premium of the delay. See the discussion at time value of money. He may not want to consume, but instead would invest in another product. The possible return he could realize in competing investments will determine what interest he charges. Length of time: Time has two effects. • Shorter terms have less risk of default and inflation because the near future is easier to predict. Broadly speaking, if interest rates increase, then investment decreases due to the higher cost of borrowing (all else being equal). Interest rates are generally determined by the market, but government intervention - usually by a central bank- may strongly influence short-term interest rates, and is used as the main tool of monetary policy. The central bank offers to buy or sell money at the desired rate and, due to their control of certain tools (such as, in many countries, the ability to print money) they are able to influence overall market interest rates. Investment can change rapidly to
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