The flow of money in an economy

The flow of money in an economy is affected by factors of demand for and supply of goods and services. In instances when there is more demand for items and there is no enough money to complete the transaction, an individual or organization is compelled to borrow from financial institutions such as banks and other credit-offering facilities to pay at a later date. However, the lender usually requires that the money will be returned having earned an interest, that is, the cost tied to borrowing a principal amount. Typically, the interest is a percentage of the principal sum of money, forming a rate. As such, the rate of interest is spread over a period of time within which the borrower is expected to have repaid the loan as well as the interest. This paper, therefore, will explore the different types of interest rates and their relationship through the fisher equation.  Additionally, it will lay out recent empirical data regarding interest rates in Canada and the models used in estimating and regulating the interest rates. Finally, it will analyze the actual data using theoretical models and offer achievements, shortcomings, and implications of the models as well as results obtained.

There are two main categories of interest rates, that is, real interest rates and nominal interest rates (Bauer 297).  The nominal interest rate is the percentage of interest accrued on a loan without adjusting for other factors such as inflation (Bauer 297).  For instance, if a borrower takes a loan worth \$100 from a bank in Canada at 8% nominal interest rate, they are expected to repay just \$108 by the end of the year.  More so, nominal rates also arise when there compounding of interest does not follow a regular frequency such as a year (Bauer 297). On the other hand, real interest rate represents the actual amount of interest a borrower is expected to pay having been adjusted for inflation.  Additionally, the real rate takes into account regular compounding, usually on an annual basis, although the compounding may also be based on other periods such as monthly or quarterly. Furthermore, since inflation is the general upsurge in price levels for goods and services in an economy, real interest rate implies that the lender includes the expected purchasing power after the loan period in the total amount to be repaid by the borrower (Haug 1059). Nevertheless, it is important to note that both nominal and real interest rates are affected by other factors apart from inflation. They include but not limited to the rate of unemployment in the economy, substitution elasticity, risk and alternatives of investments, and government spending through treasury bills and bonds.

Methodology

The nominal interest rate, assuming that interest is not compounded for the loan period, is obtained from the formula of simple interest which is:

Where i is the interest accrued, p is the principle amount borrowed, r is the rate of interest, and t is the expected time of loan repayment. Applying algebraic rules implies that

This rate represents the nominal interest rate.  As such, the equation does not incorporate any other factors that may affect the economic and subsequent need for borrowing. Although nominal interest rates are not a sufficient measure, they are used in offering a rough economic estimate of the rates across the economy.  When it is set at a low level, it implies that people are being encouraged to borrow more, for instance after a recession.  However, the assumption that the inflation will not have a short-term unexpected fluctuation must be made.

The real interest rate is calculated by the following formula:

Where ir is the real interest rate, in is the nominal interest rate, and π is the inflation (Bauer 297). The above formula is the fisher’s equation and it relates the two interest rates.  Apparently, the nominal rate is adjusted by subtracting the effects of inflation. According to the fisher’s equation, an increase in inflation would lead to a proportionate increase in nominal interest rate and this would discourage borrowing. Notably, the fisher’s assumption for the relationship between the real and nominal interest rates is that in the long term, the nominal interest rates and the inflation ought to merge so that real interest rates will gain stability.

The following tables show recent data regarding the real interest rates and inflation in Canada:

Table 1: Inflation in Canada between 2010 and 2014 (Source: Inflation in Canada)

 year 2010 2011 2012 2013 2014 inflation 2.35% 2.30% 0.83% 1.24% 1.47%

Table 2: Real Interest Rates in Canada between 2010 and 2015 (Source: The World Bank)

 Year 2010 2011 2012 2013 2014 Real interest rate -0.3% -0.4% 1.5% 1.6% 1.2%

Given the data above, it is possible to obtain the estimates of the nominal interest rates by using the fisher’s equation.  It is clear that in 2010 and 2011, the real interest rates were negative while in consecutive years it remains positive. It is also notable that during the two exceptional years in the dataset, the inflation was higher than the consecutive years.

Works cited

Bauer, Michael D. “Nominal Interest Rates and the News.” Journal of Money, Credit & Banking 47.2/3 (2015): 295-332. Print.

Haug, Alfred A. “On real interest rate persistence: the role of breaks.” Applied Economics 46.10 (2014): 1058-1066. Print.

Inflation. “Historic inflation Canada – CPI inflation.” Inflation.eu. N.p. 2016. Web. 27 Mar 2016.

The World Bank. “Real Interest Rate.” Worldbank.org. The World Bank. 2016. Web. 27 Mar 2016.

[catposts name=”Economics”]