Flashcards in week 2 Deck (11)

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1

## explain interest rates

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Time value of money is measured by interest rate.

‘Cost (price) of money’

Interest rate is always expressed as a % per annum (p.a.), unless specified.

$ Interest Amount = Principal × Interest Rate × Interest Period Duration

Suppose Sam borrowed $10,000 at 5% p.a. for one year.

In one year, he has to pay $10,000 × 0.05 (per annum) × 1 (year) = $500 as interest, as well as $10,000 principal repayment.

% (5%) is for presentation, while decimals (0.05) are for calculation.

Always convert % to decimals in this topic!

2

## explain real v normal interest rates

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Nominal interest rate

Interest rate observed in the market contains ‘real interest rate’ and ‘inflation rate’.

Real interest rate

the basic interest rate in a world of no inflation

Pure time value of money

Rate of inflation

Annual percentage rate of change in the price level, usually measured by the consumer price index (CPI).

It reflects the tendency of prices to increase over time.

Higher expected inflation implies greater interest rate required by lenders to compensate for the loss in terms of purchasing power.

3

## explain the fisher effect and real interest rates

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A simple formula, ‘Fisher Effect’ to convert nominal interest rates into real rates:

Real interest rate = nominal interest rate − inflation

4

## The real interest rate affects three private-sector components of spending

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Consumption

Investment

Net exports

5

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There is a negative relationship between real interest rates and private expenditure.

explain

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Higher (Lower) interest rate will discourage (encourage) private consumption.

Investment is more sensitive to real interest rate as real interest rate influences long-term borrowing to purchase durable capital goods.

Higher (lower) interest rate will make A$ appreciate (depreciate), which decrease (increase) net exports.

6

## explain the RBA and interest rates

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Reserve Bank of Australia (RBA) monitors nominal interest rates by targeting the overnight cash interest rates.

In low inflation environments, any decision by the RBA to change the nominal interest rates in the short run will lead to changes in real interest rates.

e.g. if the nominal cash rate is 2.5% and inflation is 1.9%, real interest rate is 0.6%.

if the cash rate increases to 2.75%, inflation would remain unchanged in the short term, so real interest rate would be 0.85%.

By targeting the overnight cash rate, the RBA can affect other interest rates quite quickly.

Longer term interest rates track the overnight cash rate closely

7

## explain simple interst

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Simple interest

Principal is constant across the life of borrowing/lending contract.

Usually applied onto short-term borrowing/lending contract (within 1 year)

8

## explain compound interest

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Interest is accrued onto the principal at the end of each interest interval

Principal is ‘growing’ across the life of borrowing/lending contract.

In other words, there will be ‘interest on interest’.

Usually applied onto long-term borrowing/lending contract (over 1 year

Typically applied to long term interest arrangement, such as bond, mortgage.

FV with compound interest: compounding

9

## explain nominal interest rate

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the standard practice for expressing interest rates, e.g. 10% per annum

the nominal interest rate does not provide a true indication of the ‘effective’ interest rate when we compare interest rate arrangements with different compounding frequency.

Which term deposit account is better? Let’s assume $10,000 principal (PV) and 1 year time to maturity

10

## explain effective annual rate

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We need to know how much interest rate the arrangement implies, effectively

Effective interest rate provides a ‘standardized’ measurement of interest rate, after considering different compounding frequency.

‘Equivalent’ interest rate if compounded annually

12% p.a. compound monthly is indifferent from ? % p.a. compound annually.

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