Question

Question 2.

1. Briefly explain the relationship between real interest rate and the nominal interest rate in an economy with the aid of a numerical example?
   
2. How would a strategy to channel your money into a savings account be affected by inflation?
   
3. If a Commercial Bank A offers its savers 9.1% annual interest rate and pays interest annually, while another Commercial Bank B offers its savers 9% annual interest rate but pays monthly. Which Commercial Bank you would deposit your money, if you intended to keep in the savings account for 5 years. Show all numerical calculations.
   

1. Identify two different Theories of Interest Rate determination.
2. List two characteristics of each theory identified above.

Answer 1

A.  real interest rate is one that is adjusted to remove the effects of inflation, reflecting the real cost of funds to the borrower and the real yield to the lender or investor. A nominal interest rate, on the other hand, refers to an interest rate that does not factor out inflation. Therefore, it is taken before inflation is taken into account.

Real interest rates should be considered predictive when the true rate of inflation is unknown or expected.

The real interest rate gives lenders and investors an idea of the real rate they receive after factoring in inflation. This also gives them a better idea of the rate at which their purchasing power increases or decreases. They can estimate their real rate of return by comparing the difference between a Treasury bond yield and a Treasury Inflation-Protected Securities (TIPS) yield of the same maturity, which estimates inflation expectations in the economy.

A nominal interest rate is the interest rate that does not take inflation into account. It is the interest rate quoted on bonds and loans. The nominal interest rate is a simple concept to understand. If you borrow $100 at a 6 percent interest rate, you can expect to pay $6 in interest without taking inflation into account. The disadvantage of using the nominal interest rate is that it does not adjust for the inflation rate.

Short-term nominal interest rates are set by central banks. These rates are the basis for other interest rates that are charged by banks and other institutions to consumers. Central banks may decide to keep nominal rates at low levels in order to spur economic activity. Low nominal rates encourage consumers to take on more debt and increase their spending. This was the case following the Great Recession when the U.S. Federal Reserve dropped its Fed Funds Rate to a range of 0.00 percent to 0.25 percent. The rate remained in this range between December 2008 and December 2015.

B . inflation is a situation of a sustained increase in the general price level in an economy. Inflation means an increase in the cost of living as the price of goods and services rise.

If we invest money in savings a/c then its interest rate is 6percent per annum and if their is inflation the value of money increases, without increase in our interest rate that means we get low profits while their is inflation.

So better invest in other things like shares and mutual funds

We have keep an eye on inflation while saving in savings account

C. We humans think to tend more profits in little span of time

That's the reason definitely I choose to invest in commercial bank B because I will get my profits with in time while comparing it to bank A

And for long term investment also I suggest bank A it's 0.1 percentage drives Investors soon

100 × 9.1percent = 9.1 +100 = 109.1 at annum

100 × 9 percentage = 9 + 100 = 109 per annum

A real interest rate is adjusted to remove the effects of inflation and gives the real rate of a bond or loan.

A nominal interest rate does not factor out inflation and is the interest rate quoted on bonds and loans.

To calculate the real interest rate, you need to subtract the actual or expected rate of inflation from the nominal interest rate.