Geoscience Reference
In-Depth Information
All of us confront this question in our everyday lives. Suppose you
want to buy your fi rst house, which costs $200,000, but you have only
$50,000 in cash. You need to get an additional $150,000. You go to the
bank and fi nd that it is willing to lend you the $150,000, but it requires
you to pay a 6 percent interest rate on the loan. A quick calculation
shows that if you were to borrow $150,000 for 30 years at 6 percent in-
terest, you would need to pay the bank $323,759.
Your fi rst instinct might be to say, “Now I know why bankers are so
rich.” But on further refl ection, you realize that the extra $173,759 is
interest and refl ects the fact that you get $150,000 of buying power
today instead of having to wait for years to become a homeowner.
Money is more valuable today than tomorrow, and that is why people
and businesses are willing to pay interest on borrowed money.
REAL VERSUS NOMINAL INTEREST RATES
We need to pause for one fi nancial detail. In my discussion of mort-
gages, the interest rate was 6 percent per year. But suppose that prices go
up by 2 percent per year. So we will be paying back in dollars that are
worth less in the future because of infl ation. How should we deal with
this fact?
When we think of interest, we usually have the “nominal” or dollar
interest rate in mind. Interest is quoted in dollar terms, meaning we pay
back dollars in the future for dollars borrowed today. But suppose prices
are going up at 2 percent per year. Then while you pay $6 for every $100
borrowed, the $6 is worth less next year. Because prices changed over
the year, you would not sacrifi ce $6 of future goods.
The concept fi nancial economists use to deal with infl ation is the
“real interest rate.” It measures the quantity of goods we get tomorrow
for goods foregone today and is obtained by correcting nominal or dollar
interest rates for the rate of infl ation. In our example, with a nominal
interest rate of 6 percent per year and an infl ation rate of 2 percent per
year, the real interest rate is 6
4 percent per year. When we borrow,
we are really only paying back 4 cents of goods next year for each dol-
lar's worth of goods borrowed this year. From now on we will talk
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