Interest Rates and Fisher Equation

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Questions and Answers

What is the nominal interest rate?

The rate of return on debt instruments

The interest rate adjusted for inflation

The interest rate not adjusted for inflation (correct)

The true cost of borrowing

According to the Fisher equation, how is the real interest rate related to the nominal interest rate and expected inflation rate?

Real interest rate = Nominal interest rate * Expected inflation rate

Real interest rate = Nominal interest rate - Expected inflation rate (correct)

Real interest rate = Nominal interest rate / Expected inflation rate

Real interest rate = Nominal interest rate + Expected inflation rate

Why is the real interest rate considered more important for economic decisions?

Because it represents the rate of return on debt instruments

Because it is adjusted for inflation

Because it reflects the true cost of borrowing (correct)

Because it fluctuates less compared to nominal interest rate

In the context of debt instruments, what are cash flows?

The streams of money payments to the holder over time Signup and view all the answers

What does the Fisher equation state about the relationship between nominal and real interest rates?

Nominal interest rate equals real interest rate plus expected inflation Signup and view all the answers

What is the principal in the context of a simple debt instrument like a loan?

The amount to be repaid to the lender at the maturity date Signup and view all the answers

What is the formula to calculate the future value of a loan after one year?

FV = PV(1+i) Signup and view all the answers

What does 'discounting the future' refer to?

Calculating the present value of dollars received in the future Signup and view all the answers

What is the yield to maturity on a loan if $100 is borrowed and the borrower has to pay back $110 after one year?

10% Signup and view all the answers

What is the concept that allows comparison of values of different market instruments with varying timing of their payments?

Present value Signup and view all the answers

If you lend $100 for two years at a 10% interest rate, what will be the future value of your loan?

$121 Signup and view all the answers

What does the formula PV= FV / (1+i)^n represent?

Present value of a loan Signup and view all the answers

What does 'simple-interest rate' refer to in the context of loan calculation?

Interest calculated on principal only Signup and view all the answers

What does calculating 'the simple-interest rate' involve?

Calculating interest based on principal amount only Signup and view all the answers

Study Notes

Interest Rates and Debt Instruments

The nominal interest rate is the rate of interest before adjusting for inflation.
The Fisher equation states that the real interest rate is equal to the nominal interest rate minus the expected inflation rate.
The real interest rate is considered more important for economic decisions because it reflects the true purchasing power of the borrower.

Debt Instruments and Cash Flows

Cash flows refer to the stream of payments made over time in a debt instrument, such as a loan or bond.
In a simple debt instrument like a loan, the principal is the initial amount borrowed.

Calculating Future Value and Yield to Maturity

The formula to calculate the future value of a loan after one year is FV = PV x (1 + i), where FV is the future value, PV is the present value, and i is the interest rate.
The yield to maturity on a loan is the total return on investment, considering the interest rate and the timing of payments.
In the example where $100 is borrowed and the borrower has to pay back $110 after one year, the yield to maturity is 10%.

Discounting the Future and Present Value

Discounting the future refers to the concept of reducing the value of future cash flows to their present value, taking into account the time value of money.
The formula PV = FV / (1 + i)^n represents the present value of a future cash flow, where PV is the present value, FV is the future value, i is the interest rate, and n is the number of periods.

Simple Interest Rate and Loan Calculation

The simple-interest rate refers to the interest rate charged on the initial principal amount of a loan.
Calculating the simple-interest rate involves multiplying the principal amount by the interest rate to determine the interest paid over a period.

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Description

Test your knowledge of interest rates, including nominal and real interest rates, and the Fisher equation which relates nominal and real interest rates to the current and expected inflation rates.