realinterestrate2

# realinterestrate2 - Real Interest Rates Mark L J Wright...

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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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We call i the interest rate because it is applied proportionally to all of the amount B you borrow.
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