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Real Interest Rates
Mark L. J. Wright
January 14, 2008
Abstract
A few students remakred that they had trouble following the derivation of
the real interest rate in class. These notes are meant to clarify that derivation.
NOMINAL INTEREST RATES
When ever you deposit money in the bank, you do so in the expectation that you
will get your money (your principal) back
plus interest
.
Likewise, whenever you
borrow money, you expect to pay back both the principal and the interest.
If we think of measuring both deposits and loans in terms of units of money (say,
for example, dollars), then the nominal interest rate tells you the extra amount of
money you get back (if you deposit) or pay (if you borrow). Suppose you borrow
$1
;
and you repay more than
$1
:
Then the extra amount you pay back is the nominal
interest rate or
i;
and
$ (1 +
i
)
;
is the total amount you repay.
Similarly, if you borrowed
$
B
dollars, you would
repay
$ (1 +
i
)
B:
1
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View Full DocumentWe call
i
the interest
rate
because it is applied proportionally to all of the amount
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 Spring '08
 Serra
 Interest Rates

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