Question

Question 2. (a) Briefly explain the relationship between the inflation rate and the real interest rate in an economy with the aid of a numerical example? (b) You had an option to either invest in a savings scheme or business venture where you had to borrow the funds. Assume that both investment options have the same risk and offer the same returns at the current interest rate. If it was later established, just before you entered a contract, that general prices in the economy will decrease rapidly over the next few years, what would be your decision, and why? (c) If a Commercial Bank A offers its savers 7.1% annual interest rate and pays interest annually, while another Commercial Bank B offers its savers 7% annual interest rate but pays monthly. Which Commercial Bank you would deposit your money, if you intended to keep in the savings account for 4 years. Show all numerical calculations. (d) i. Identify two different Theories of Interest Rate determination. ii. List two characteristics of each theory identified above.  

Answer 1

According to Fischer hypothesis, i = r + expected inflation, where an increase in the expected inflation leads to increase in nominal interest rate. Now by transposing inflation to the left, i - expected inflation = r, we can see that a rise in the expected inflation leads to reduced real interest rates. Thus, inflation and real interest rates have inverse relation.

B). If the general price level will b decrease over the years, I would be going for depositing my money in the savings bank account. This is because reduced price levels would mean that the real interest rates would rise, and thus it would be beneficial for me to deposit my money in savings bank account as against investing it in a business, since the return on business will be uncertain due to reducing price levels of the commodities in the market.

C). Consider that I have $1000 to deposit.

With bank A, on a 7.1% interest per annum, I'll be getting = 1000(1.071)^4 = $1315.70

With bank B, on a 7.0% interest per month, I'll be getting = 1000(1.07)^28 = $6648. 83

Thus, I'll be depositing my money in Bank B

D) Productivity Theory

1. According to this theory, interest is calculated as a result of capital that has been used up for production purposes.

2. It focuses only on production or commercial borrowings, and fails to procide evidence on how interest can be calculated for consumption purposes.

2. Classical or Real Theory

This theory helps in determination of interest rates through demand and supply forces. Demand is referred to as the demand for investment while supply is the supply of savings

This theory assumes full employment of resources which is not possible in the real world.