Nominal and Real Interest

Rates; Inflation
Class 6
 Nominal Interest Rates
• Interest rates can be for less than or more than a
year
– E.g. monthly interest rate
• r = (Interest rate per period)x(no. of periods)
– E.g. a 1.5% per month interest rate translates
into a nominal interest rate of 18% per year
– Or 4.5% per quarter
• Limitation: Ignores the time value of money
– We need to find the effective Interest Rate
 Effective Interest Rates
• Consider a nominal rate of 12%
compounded annually
– In 1 year, Rs. 100 becomes Rs. 112
• Consider a nominal rate of 12%
compounded semi-annually
– There is a 6% compounding every 6 months
1
2

100

• F = 100x(1+0.06)2
– F = Rs. 112.36
 Effective Interest Rate

• i = (1 + r/m)m – 1
– i = Effective interest rate
– r = nominal interest rate
– m = number of compounding periods
 Example
• A credit card carries an interest rate of 2%
per month on the unpaid balance. What is
the semi-annual interest rate?

• i = (1 + .12/6)6 - 1
– i = (1.02)6 - 1
– i = 0.1262
– i = 12.62%
 Continuous Compounding
• As compounding periods become shorter
and shorter, continuous compounding
occurs
• ‘m’ tends to infinity

• Limit(m -> ∞)[(1 + r/m)m – 1] = er – 1

– i = er – 1
 Example
• If a woman deposits Rs. 500 every 6
months for 7 years, how much money will
she have in her account after she makes
her last deposit if the interest rate is 20%
per year compounded quarterly?
• Effective semi-annual rate = (1.05)2 – 1
– i = 10.25%
• Find F = 500 (F/A, i, 14)
– F = Rs. 14,244.50
 Example – Interest periods
greater than deposit periods
• Calculate the amount of money that would
be in a person’s savings account after 12
months if deposits were made as shown
below. Assume that the bank pays 6% per
year compounded semiannually.

0 1 2 3 4 5 6 7 8 9 10 11 12

100 90 80 75 85 70
 Solution
• Treat deposits in-between periods as
earning simple interest
• After 6 months, first deposit =
– [100 + 100x.03x5/6] + [90 + 90x.03x3/6] + 80
– = Rs. 273.85
• Second deposit =
– [75+75x.03x5/6] + [85+85x.03x4/6] +
[70+70x.03x1/6]
– = Rs. 233.93
• F = 273.85x(1.03) + 233.93 = Rs. 516
 Inflation
• Inflation brings down the value of money
• Consider investing Rs. 5000 for four years
from now at a rate of 8%
– F = Rs. 6,803
• However, if inflation is 10%, then
– Rs. 6,803 four years from now can only buy
you around Rs. 4640 worth of goods in
today’s terms
– Your money has lost some of its value
 Dealing with Inflation
• ‘f’ = rate of inflation

• P = Fx[1/(1+f)n]x[1/(1+i)n]
– = F/(1+i+f+if)n
– Set i+f+if = if
– P = F/(1+if)n
 Example
• An alumnus decides to donate to IITM and
offers the following options:
– A: Rs. 60,000 now
– B: Rs. 16,000 per year for 12 years beginning
next year
– C: Rs. 50,000 three years from now and
another Rs. 80,000 five years from now
If IITM can earn 12% on its assets and inflation
is expected to be 11%, which plan should be
chosen?
 Solution
• if = 0.12+0.11+0.12x0.11 = 0.243 (24.3%)
• P for Plan A = Rs. 60,000
• P for Plan B = 16,000(P/A, 24.3%, 12)
– = Rs. 61,003.46
• P for Plan C = 50,000/(1.243)3 +
80,000/(1.243)5
– = Rs. 52,995.84
• Hence Accept Plan B
 Cost Indices
• Cost Indices automatically transfer value in the past to
value today
– They take inflation into account
• E.g: You are interested in estimating the cost of skilled
labour for a job. You find a similar project in terms of
complexity and magnitude that was completed 5 years
ago, where the ENR skilled labour index was 3496.27.
The skilled labour cost for that project was Rs. 3,60,000.
If the ENR skilled labour index now stands at 4038.84,
what is the expected cost of skilled labour for your
project?
 Solution
• Original cost = Rs. 3,60,000

• Current cost = 360000*4038.44/3496.27

– = Rs. 415,825
 Example
• You want to purchase a new cycle for Rs.
8,500. You plan to borrow money from the
bank and repay it monthly over a period of
4 years. If the nominal interest rate is 12%
per year compounded monthly, what will
your monthly installments be?
• A = 8500(A/P, 1%,48)
– A = Rs. 223.81
 Example
• A Rs. 50,000 bond with an interest rate of
10% per year payable semi-annually is
currently for sale and is due in 15 years. If
the rate of return required by investors is a
nominal 16% per year compounded
annually, and if the inflation rate is
expected to be Rs. 4.5% per semi annual
period, how much should be paid for the
bond?
 Solution
• The bond will pay you the face value at the
end of the term and 10% of the face value
every year
– Or, Rs. 2,500 semi annually
• If = 0.08 + 0.045 + .08x.045 = 0.1286
• P = 2500(P/A, 12.86%, 30) + 50000(P/F,
12.86%, 30)
– P = Rs. 20,251
Thank You