Geoscience Reference
In-Depth Information
about real interest rates because infl ation just confuses the measure-
ments.
A DISCOUNTING EXAMPLE
The following example illustrates the issues posed by discounting.
Suppose a sterling character is selling a special bond that pays $1,000
in real terms (in dollars corrected for infl ation) in 50 years. What is the
maximum amount that you would be willing to pay today for such a
bond?
You turn to a trusted fi nancial consultant. She advises you to calcu-
late the appropriate current contribution by taking the future $1,000
and “discounting” its value back to the present using an appropriate dis-
count rate. That discount rate should refl ect the amount you could earn
on equivalent investments over the same period. The $1,000 is infl ation
corrected, so we want to use a real discount rate. In addition, we need to
recognize that investments always carry some kind of risk. So in the case
of the special bond, we might need to add a risk premium. We would
need to recognize that our sterling character might turn out to be the
bankrupt Lehman Brothers or a Cyprus bank rather than Uncle Sam.
So how much is the $1,000 bond worth today? I will use 4 percent
for our hypothetical investment scenario. Applying this discount rate to
the $1,000 bond would yield a present value of $141. This is the right
value because if you take $141 and invest it for 50 years at a compound
interest rate of 4 percent per year, the end value would be $1,000.
DETERMINANTS OF INTEREST
What is the underlying economic reason for interest? Interest re-
fl ects the fact that investments are productive. In other words, if the
economy puts resources into investment projects, the projects yield more
resources in the future. This applies to building a factory, sending chil-
dren to school, investing in energy-saving appliances, or writing better
software. Typically, an investment of $100 in new capital would yield
between 4 and 20 percent per year in more goods in the future. If the
return is 4 percent, this means that to get $1 next year requires only
$1/$1.04
=
$0.96 today.
