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Sem 5 Prep
← Money & BankingWhat determines interest rates

Formulas for this chapter

Real interest rate, linear form

ir = i - pi(e)

Quick conversions, and whenever the Drive slides or the exercise on slide 13 are the reference. Good enough when both rates are small.

ir
Real interest rate, in per cent
i
Nominal interest rate, the rate actually quoted
pi(e)
Expected inflation rate over the same period

Fisher effect, exact form

(1 + N) = (1 + R)(1 + I) N = (1 + R)(1 + I) - 1 R = (1 + N) / (1 + I) - 1

The professor's own statement, and the one to use when either rate is large. The gap against the linear form is always the cross term R x I.

N
Nominal interest rate, as a decimal
R
Real interest rate, as a decimal
I
Inflation rate, as a decimal

Error in the linear approximation

Error (percentage points) = R x I x 100

To decide in one second whether the shortcut is safe. At 3% and 5% the error is 0.15 points; at 10% and 20% it is 2 points.

R
Real rate as a decimal
I
Inflation rate as a decimal
Step 1 of 22
The ideaTheory

Rent for money

An interest rate is a rent. You are renting money for a year, and the rate is the rent.

Like any rent, it is set by how many people want to rent and how much is available to rent out.

That is the whole of the loanable funds theory. Everything else in this chapter is a list of the things that change how many want to rent, or how much is on offer, and one piece of arithmetic that separates the rent you quote from the rent you actually collect after inflation.

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