econ 4 - Dr. Mohammed Alwosabi Econ 141 - Ch.4 Notes on...

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Dr. Mohammed Alwosabi Econ 141 - Ch.4 1 Notes on Chapter 4 Investment, Saving, and the Interest Rate ± To understand the investment and the saving decisions we have to understand the meaning of the interest rate and distinguish between nominal interest rate and real interest rate. Classical theory treated saving as a direct function of the rate of interest and investment as an inverse function INTEREST RATE ± Interest rate is the price of fund (loan). It is the rate of interest charged for the use of money, usually expressed as an annual percentage. The rate is derived by dividing the amount of interest by the amount of money borrowed. ± Example: If a bank charged $50 a year to borrow $1,000, the interest rate would be 5%. ± Nominal (money) interest rate o Nominal interest rate (i) is the interest rate expressed in terms of money. It is the actual amount paid as interest per unit of currency borrowed for each period. o When people borrow money from a bank, the bank charges the nominal interest rate . When you buy a car from a dealer and pay by installments, the dealer charges you the nominal interest rate .
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Dr. Mohammed Alwosabi Econ 141 - Ch.4 2 ± Real interest rate o Real interest rate (r) is the nominal interest rate adjusted for inflation. o The real interest rate is the opportunity cost of investment (and consumption). o Investment, saving and consumption all depend on real interest rate (r) rather than nominal interest rate (i). o The real interest rate (r) = nominal interest rate (i) - inflation rate o Thus, the nominal interest rate = real interest rate (r) + inflation rate o In an open economy, the real rate of interest is determined by saving, investment and foreign financing (otherwise known as net exports). ± Example: o Suppose a bank has made a one-year loan of 1000 dinars with nominal interest rate = 5%. At the end of the year, the bank would receive 1050 (100 * 1.05). That is, the bank gained 5%. Suppose the inflation rate of that year = 4%. The bank real gain or real interest rate = 5% - 4% = 1% ± Example: If the nominal interest rate charged was 3% when expected inflation was 3%, then, 3% is necessary just to compensate the lender for inflation (loss of purchasing power). Thus, the real rate of interest would be 0%. ± Exercise: If real interest rate is 7 % and inflation rate is 6 %. What would be the nominal interest rate?
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Dr. Mohammed Alwosabi Econ 141 - Ch.4 3 INVESTMENT DECISION ± Potential GDP depends on the quantity of productive resources. The growth rate of PGDP depends on how rapidly the resources grow. ± One of the major resources that is important to grow is the economy's capital stock. ± The economy's capital stock is measured by its total physical quantity and quality of plants, machines, equipments, buildings, highways, schools, inventories of raw materials and semi-finished goods, etc. ± The Capital stock includes business capital as well as inventories.
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econ 4 - Dr. Mohammed Alwosabi Econ 141 - Ch.4 Notes on...

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