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Predict how interest rates act as incentive for savers and borrowers

Play Poster for "The War of Wealth," 1895
Play Poster for "The War of Wealth," 1895

Interest


Multimedia.pngA simple and informative video on interest rates and their function.


The cost of borrowing, which compensates lenders for the RISK they take in making their money available to borrowers.
  • Without interest there would be little lending and thus a lot less economic activity.
  • Some American states also have usury laws, imposing tough conditions on the terms set by lenders, although not actually prohibiting interest. Yet, as the recent rise of a substantial banking industry in Islamic Middle Eastern countries shows, when economic growth is a priority, ways can usually be found to pay lenders to lend.

Compounding Interest versus Simple Interest
Compounding interest is "interest on interest."
  • It is a method of calculating interest where the interest is added to the original principle.
  • This new value is now our principle for the next time period. In this method the interest earned in past terms can earn interest in future terms.
  • Simple interest is a type of interest that is paid only on the original amount deposited and not on past interest paid.


Go here for an interest rate calculator

Interest rate

Interest is usually expressed at an annual rate: the amount of interest that would be paid during a year divided by the amount of money loaned.
  • Developed economies offer many different interest rates, reflecting the length of the loan and the riskiness and wealth of the borrower.
  • People often use the term “interest rate” when they mean the short-term interest rate charged to banks. For instance, when a central bank raises or cuts interest rates, it changes only the price it charges to banks borrowing money overnight, expressed as an annual rate.
  • Bond yields are a better measure of the interest rate on loans that do not have to be repaid for many years.
  • Unlike short-term interest rates, bond yields are determined not by central bankers but by the supply and demand for money, which is heavily influenced by the expected rate of inflation.
  • This holds true because of liquidity. When interest rates are low, borrowers are at an advantage and there is a higher flow of hard cash; when interest rates go up, it becomes more advantageous to hold money in the form of bonds to get a greater return, and thus liquidity goes down.
Federal Reserve Chair Janet Yellen, 2014
Federal Reserve Chair Janet Yellen, 2014

external image Dollar-teken.pngGo here for a Compound Interest Calculator which you can type in hypothetical money savings and interest rates.

Rise and Decline in Interest Rates


The specific effects of inflation and deflation are mixed and fluctuate over time.
  • Deflation is typically caused by depressed economic output and unemployment. Lower prices may eventually encourage improvements in consumption, investment, and foreign trade, but only if the fundamental causes of the original deterioration are corrected.
  • Inflation initially increases business profits, as wages and other costs lag behind price increases, leading to more capital investment and payments of dividends and interest.
  • Personal spending may increase because of “buy now, it will cost more later” attitudes; potential real estate price appreciation may attract buyers.
  • Domestic inflation may temporarily improve the balance of trade if the same volume of exports can be sold at higher prices. Government spending rises because many programs are explicitly, or informally, indexed to inflation rates to preserve the real value of government services and transfers of income. Officials may also anticipate paying larger budgets with tax revenues from inflated incomes.

Multimedia.pngFor a short video with a clear explanation of Inflation, go here.

What an Interest Rate Increase Means for Real People from CNN Money, March 19, 2015

The image above shows a rising interest rate.
The image above shows a rising interest rate.


Sources:
http://www.economist.com/research/economics/alphabetic.cfm?letter=I
http://encarta.msn.com/encyclopedia_761553744_2/Inflation_and_Deflation.html#p17
http://jwilson.coe.uga.edu/emt668/EMAT6680.2004.SU/Buckelew/assignment12/assignment12.html