9780321818171_berk_ch03

In the same way that a currency exchange rate allows

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Unformatted text preview: ch we can exchange money today for money in the future is determined by the current interest rate. In the same way that a currency exchange rate allows us to convert money from one currency to another, the interest rate allows us to convert a currency from one point in time to the same currency at another point in time. In essence, an interest rate is an exchange rate across time. It tells us the market price today of money in the future. Suppose the current annual interest rate is 7%. By investing $1 today, we can convert this $1 into $1.07 in one year. Similarly, by borrowing at this rate, we can exchange $1.07 in one year for $1 today. More generally, we define the interest rate, r, for a given period as the interest rate at which one currency can be borrowed or lent over that period. In our example, the interest rate is 7% and we can exchange $1 today for (1 0 .7) dollars in the future. In general, we can exchange $1 today for (1 r) dollars in the future, and vice versa. We refer to (1 r) as the interest rate factor for cas...
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