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Chapter 8 Interest Rates

1. What is the interest rate, and how is it determined?

• Price that equates the demand for and the supply of loanable funds; The interest rate is the yearly price charged by a lender to a borrower in order for the borrower to obtain a loan. This is usually expressed as a percentage of the total amount loaned.

• Figure 8-1 shows how interest is determined; supply versus demand

2. Describe how interest rates may adjust to an unanticipated increase in inflation.

• When inflation is volatile from year to year, it becomes difficult for individuals and

businesses to correctly predict the rate of inflation in the near future.

Brie fly describe the time value of money—math of finance whereby interest is earned over time by saving or investing money

a. Present value—value today of a saving amt or investment

b. Future value—value at a specified time or date in the future of a savings amt or investment

i. Future value=Present value + (present value x interest rate)

ii. Future value=Present value x (1+ Interest rate)

2. Explain simple interest—interest earned only on the investment’s principal

3. Describe the process of compounding and the meaning of compound interest

a. Compounding is an math process whereby an initial value increases or grows at a compound interest rate over time to reach a value in the future

b. Compound interest involves earning interest on interest in addition to interest on the principal

c. Future value = present value x[(1x interest) x (1+interest rate)]

4. Briefly describe how inflation or purchasing power impacts stated or nominal interest rates.

a. One of the most important economic concepts is inflation. At its most basic level, inflation is simply a rise in prices. Over time, as the cost of goods and services increase, the value of a dollar is going to go down because you won’t be able to purchase as much with that dollar as you could have last month or last year. Of course, it seems like the cost of goods are always going up, at least to an extent, even when inflation is thought to be in check.

b. It is important to note that some amount of inflation is considered normal (actually, as we explain below, because of its relationship with unemployment, some inflation is actually desirable). While the annual rate of inflation has fluctuated greatly over the last half century, ranging from nearly zero inflation to 23% inflation, the Fed actively tries to maintain a specific rate of inflation, which is usually 2-3% but can vary depending on circumstances.

c.

5. What is discounting? Give an illustration

a. Discounting is an math process whereby a future value decreases at a...

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