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Unformatted text preview: o several elements:
• Real interest rate, r • Rate of inflation, IR • Transaction costs, TC • Risk factor, SR • The interest rate that banks pay to the government (i.e., to the Federal Reserve) is the sum r + IR. – This is the nominal interest rate. • The interest rate that lowrisk firms pay to banks is the – This interest rate is called the Prime Rate. sum r + IR + TCm + SRm, where TCm and SRm are minimum transactions costs and risk costs, respectively. The Components of Interest Rate The Components of Interest Rate Cont.
• Lenders (banks) analyze projects proposed by entrepreneurs before financing them. projects and to determine SR. • They do this to assess the riskiness of the • Creditrating services and other devices are used by lenders (and borrowers) to lower TC. Some Numerical Examples Some Numerical Examples
(1) If the real interest rate is 3% and the inflation rate is 4%, then the nominal interest rate is 7%. (2) If the real interest rate is 3%, the inflation rate is 4% and TC and SR are each 1%, then the Prime Rate is 9%. Discounting Discounting
• Discounting is a mechanism used to compare streams of net benefits generated by alternative allocations of resources over time. • There are two types of discounting, depending on how time is measured. • If time is measured as a discrete variable (say, in days, months or years), discretetime discounting formulas are used, and the appropriate real interest rate is the "simple real interest rate". • If time is measured as a continuous variable, then continuoustime formulas are used, and the appropriate real interest rate is the "instantaneous real interest rate". • We will use discretetime discounting in this course. • Hence, we will use discretetime discounting formulas, and the real interest rate we refer to is the simple real interest rate, r. • Unless stated otherwise, assume that r represents the simple real Lender’s Perspective Lender’s Perspective
• From a lender's perspective, 10 dollars received at the beginning of the current time period is worth more than 10 dollars received at the beginning of the next time period. received today to someone else and earn interest during the current time period. • That's because the lender could lend the 10 dollars • In fact, 10 dollars received at the beginning of the current time period would be worth $10(1 + r) at the beginning of the next period, where r is the interest rate that the lender could earn on a loan. A Different Perspective & A Different Perspective & Discounting Cont.
• Viewed from a different perspective, if 10 dollars were received at the beginning of the next time period, it would be equivalent to receiving only $10/(1 + r) at the beginning of the current time period. discounted by multiplying it by 1/(1+r)....
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