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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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 Fall '06
 Hadaway
 Corporate Finance, Interest, Interest Rate

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