Real Interest Rate determination (Exam 3)

Gov borrowing effect on private spending

"crowds out" private spending (mostly)

total factor productivity

physical and human capital changes

interest rate

price paid to a lender for borrowing funds over time

Kyle deposits $5000 into a savings account that pays an annual interest rate of 5%, compounded monthly. The amount in the account after 10 years is:

$8235.05 (see picture)

Ex. Henley lends $100 to Maddy at a 6% annual interest rate, with principal and interest due in 1 year

100*(1+0.06) = $106

Ex. Henley lends $100 to Maddy at 6% interest rate, with principal and interest due in TWO years

100*(1.06)*(1.06) = $112.36 Extra $0.36 is the interest that accumulated on interest

Compound Interest Formula

A=P(1+r/n)^nt

D/S equilibrium and surplus

At EQ, both sides benefit (both gain)

interest rate expressed as

a PERCENT of the principle

real interest rate

adjusted for inflation - takes into account PPM

How to make compound interest formula accurate

all terms have to be expressed in the same TIME (years, quarters, months)

principal

amount borrowed

demand for loanable funds

borrowers MAX willingness to pay - downward sloping line (higher interest rate = less willing)

Government borrowing

borrows to finance its expenditures demand increases (shifts up/right) - interest rate rises - private savers save MORE - private borrowers borrow LESS

Savers become less patient

decrease supply curve (up/left) quantity of loanable funds decreases higher new real interest rate, r*

total factor productivity increases

increases demand (up/right shift) higher new real interest rate, r*

population ages (2 parts)

initially: increases SUPPLY (shift down/right) then: decreases SUPPLY (shift up/left)

compounding interest

interest paid on interest

do higher interest rates reduce borrowing

never reason from a price change sometimes when rates rise, L* decreases sometimes higher rates are met with higher L* (increase in productivity)

interest rates are typically reported as ____ rates? (ex. mortgage)

nominal

real interest rate formula

real interest rate = nominal interest rate - inflation rate (π)

nominal interest rate

regardless of inflation (purchasing power of money)

Supply of loanable funds

saver's MIN willingness to accept - upward sloping - opportunity cost