RBA Rates Flashcards
What is the real rate of interest, and how is it determined?
The real rate of interest measures the return earned on savings and it represents the cost of borrowing to finance capital goods.
The real rate of interest is determined by the interaction between companies that invest in capital projects and the rate of return businesses can expect to earn on investments in capital goods, and individuals’ time preference for consumption.
Graphically, it is that point when the desired saving level equals the desired level of investment in the economy.
When are the nominal and real interest rates equal?
The only time the nominal and real interest rates are equal is when the expected rate of inflation over the contract period is zero.
If demand for money (loanable funds) increases, what happens to the level of interest rates?
An increase in the demand for money will shift the demand for loanable funds up and to the right, increasing interest rates (at least in the short term).
If the money supply is increased, what happens to the level of interest rates?
An increase in the money supply shifts the supply of loanable funds to the right, lowering interest rates (again at least in the short term).
The one-year real rate of interest is currently estimated to be 5 per cent. The current annual rate of inflation is 2 per cent, and market forecasts predict the annual rate of inflation to be 4 per cent. What is the current 1-year nominal rate of interest?
Assuming the Fisher effect, the current 1-year nominal rate should be 9 percent, the sum of the real rate (5%) plus the expected inflation rate (4%), an approximate but illustrative way of estimating the answer. The correct way to deal with compounding rates is to multiply (1+.05)(1+.04) - 1 = 9.20%.
Can interest rates be negative? If so, under what circumstances and has this ever happened?
Yes, however they are rarely observed in global financial markets. The Fischer equation suggests that a negative interest rate could occur when the expected rate of deflation (a negative term) exceeds the real rate of interest.
The real rate of interest is always positive because we assume that human nature is such that nearly all market participants have a positive time preference for consumption. The real rate of interest is always positive because we assume that human nature is such that nearly all market participants have a positive time preference for consumption.
Practically speaking, negative interest rates might occur when a country is in a deep and prolonged recession. During such a time, the real rate of interest should be low and the economy could suffer falling asset prices (deflation).
Eg: In November 1998, the interest rate on Japanese Treasury bills declined to a negative interest rate.
Imagine you borrow $500 from your roommate, agreeing to pay her back the $500 plus 7 per cent nominal interest in 1 year. Assume inflation over the life of the contract is expected to be 4.25 per cent. What is the total amount you will have to pay her back in a year? How much of the interest payment is the result of the real rate of interest?
You will pay her back $535 ($500 x 1.07) in one year, of which $13.75will be a result of the real interest rate ($500 x 0.0275).
Real interest rate is calculated as;
7% nominal rate – 4.25% inflation =2.75%
Your parents have given you $1,000 a year before your graduation so that you can take a trip when you graduate. You wisely decide to invest the money in a bank term deposit that pays 6.75 per cent interest. You know that the trip costs $1,025 right now and that the inflation for the year is predicted to be 4 per cent. Will you have enough money in a year to purchase the trip?
Yes. The term deposit will be worth $1,067.50 at the end of the year ($1,000 x 6.75% + $1000), and the price of the trip will be $1,066 ($1,025 x 4% + $1,025). The term deposit will be able to cover the trip.
