Inflation Notes - A Note on Inflation, Interest rates,...

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A Note on Inflation, Interest rates, Depreciation and Capital Budgeting What is Inflation? What is its primary effect? Inflation arises due to “excessive” money supply in the economy, in the sense that “there is too much money chasing too few goods.” It erodes the purchasing power of currency (consumption potential) over time. The inflation rate (in %) depends on differences in interest rates and productivity among various countries. Countries with higher productivity have lower inflation rates. If there is an interest rate differential between two countries, the country with the lower interest rate will face a lower demand for its currency. There is then “excess supply” of this currency so that there is “too much money chasing too few goods.” Thus, the country with the lower interest rate will face inflation pressures. A. Inflation and Interest Rates What is the difference between Nominal and Real Interest Rates? An interest rate that is unadjusted for changes in purchasing power (inflation) is the “nominal interest rate.” When adjusted for purchasing power effects, it is a “real interest rate.” With positive inflation rates, the real interest rate is less than the nominal interest rate. Example to Illustrate Nominal v. Real Interest Rates A pizza costs $10.00 in January 2003. If the US inflation rate is 4%/yr then you would need $10.00 * 1.04 = $10.40 to buy the same pizza in January 2004. In effect, $10.40 in 2004 is equivalent to $10.40/1.04 = $10.00 in 2003, without considering time value of money. Suppose that the
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Inflation Notes - A Note on Inflation, Interest rates,...

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