Economics Online Tutor
Interest Rates
and
The Effects of Inflation on Interest
Rates
RELATED LINK:


INFLATION (MAIN PAGE)
What are interest rates?


When a borrower (debtor) and a lender (creditor) enter into a contract, the
borrower receives funds at the present time from the lender in exchange
for paying the funds back at a later time.  In essence, the borrower has
gained control of the use of money that is owned by the lender.  This
includes the opportunity to invest this money for the purpose of earning
income for the borrower.

The lender is willing to enter into such a contract because income for the
lender is involved.  The borrower agrees to pay back money in addition to
the amount of money borrowed in order to compensate the lender for
providing this service.  The amount of funds borrowed is called principle.  
The amount in addition to the principle that the borrower agrees to pay to
compensate the lender is called interest.

The amount of the interest, stated as a percentage of the principle and
annualized, is called the interest rate.  This concept is known as the time
value of money.

To the borrower, interest represents a cost of borrowing, called interest
expense.  To the lender, interest represents income on an investment,
since the lender is investing funds in the transaction in order to earn
income.  This is called interest income.

This analysis applies to the bond market as well as such transactions as
bank loans, because bonds are actually contracts between lenders and
borrowers.
The effects of inflation on interest rates


When inflation is present, the borrower receives money that is worth more than the money that is paid
back.  In order for such a transaction to take place, both the borrower and the lender will have to agree
on the terms.  This can occur as long as the effects of inflation are built into the contract.

When the inflation rate is included as part of the stated interest rate, the lender will be compensated for
the loss of purchasing power during the time that the loan is outstanding, or during the time that control
over the money is transferred from the lender to the borrower.  By including the inflation rate in the
stated interest rate, the contract can be mutually acceptable to both the borrower and the lender,
despite the loss of purchasing power over time.

The stated interest rate, which includes the adjustment for inflation, is called the nominal interest rate.  
The effective interest rate, after the effects of inflation are discounted, is called the real interest rate.  
The formula for this is:

REAL INTEREST RATE = NOMINAL INTEREST RATE MINUS INFLATION RATE

Including the inflation rate in the nominal interest rate will mean that neither the borrower nor the
lender can gain a windfall profit at the other's expense simply because of inflation.

The problem with that concept is that the contract involves payments to be made in the future.  In order
to include the inflation rate in the nominal interest rate, the future inflation rate must be known.  Since it
is impossible to know with certainty what the future inflation rate will be, the rate of inflation must be
forecast.  This is accomplished using the concept of expected, or anticipated, inflation.

The anticipated inflation rate is the expected rate of inflation over the length of the contract.  As long as
the actual inflation rate turns out to be equal to the anticipated inflation rate, inflation will not
redistribute wealth between the parties to the contract.  Each party will receive a perceived benefit from
the transaction.

However, when the actual inflation rate differs from the anticipated inflation rate, wealth is redistributed
between the parties simply because of the existence of inflation.

When the actual rate of inflation is greater than the anticipated rate of inflation, the borrower ends up
paying back the loan with money that is worth less than contracted for.  In that case, the borrower gains
at the expense of the lender.  Wealth is redistributed from the creditor class to the debtor class.

When the actual rate of inflation is less than the anticipated rate of inflation, the opposite occurs.  The
borrower ends up paying back the loan with money that is worth more than contracted for.  In that case,
the lender gains at the expense of the borrower.  Wealth is redistributed from the debtor class to the
creditor class.


It should be worth noting that this analysis holds for all contracts involving interest rates.  This means
that the debtor class includes households with outstanding personal loans, homeowners with
outstanding mortgages, corporations with outstanding bonds, and governments with outstanding
bonds.  The creditor class includes banks and other financial institutions, as well as investors in
corporate and government bonds.

For example, when the actual rate of inflation is greater than the anticipated rate of inflation, wealth is
redistributed from the investor class to the taxpayer class, in the case of the government's debt.  When
the actual rate of inflation is less than the anticipated rate of inflation, wealth is redistributed from the
taxpayer class to the investor class.  And in the case of foreign ownership of bonds, wealth can be
transferred from one country to another.
At any given time, different rates of interest will be present for different transactions and different types
of transactions.  This is because any given interest rate will have at least four different components,
which can vary from transaction to transaction (and from situation to situation):

The time value of money: this is the rate of interest that would induce a lender to enter into a
transaction in a risk-free environment.  This amount would vary with the state of the economy, but would
be theoretical in nature, since risk is always involved.  It would be equal to the opportunity cost of the
transaction.

Risk premium: this is the portion of the interest rate, in addition to the time value of money, that is
associated with the risk of default.

Liquidity and marketability: All else equal, a loan that is liquid and marketable would be preferable to a
loan that is less liquid or less marketable.  A higher interest rate on the less liquid and less marketable
loan would compensate for this difference.

Anticipated inflation: The portion of the interest rate that is paid to compensate the lender for the
decrease in purchasing power due to inflation during the time that the loan proceeds are outstanding.  
This is explained in more detail below:
RELATED LINK:

INFLATION (MAIN PAGE)
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