4. Interest Rates (Ch7)

Principles of Macroeconomics (with Xtra!)

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I nterest represents the cost of borrowing money over a period of time—the price that lenders charge borrowers for the use of the lenders’ money. Interest is paid in several ways. Simple interest is expressed as a percentage of the principal over a year. A loan at 6 per cent means $6 in annual interest for every $100 borrowed or invested. Compound interest occurs when calculations of interest are made on the principal plus accumulated interest. For instance, a 4.25 per cent annual interest rate compounded monthly becomes, in effect, a 4.33 per cent annual interest rate. Nominal and real interest rates Interest rates have two components: a portion that covers expected inflation , called the inflation premium, and a portion that represents the real rate of return. The expected real rate of interest is the difference between the nominal rate of interest and the expected rate of inflation. For example, with a nominal interest rate of 6 per cent and an expected rate of inflation of 2 per cent, the expected real rate of
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This document was uploaded on 02/07/2008.

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