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When we examine how money affects economic activity, we

will focus on the impact of the interest rate.

Something we've already talked a lot about, but haven't yet really defined.

Technically, the interest rate is the amount of interest paid per

unit of time, expressed as a percentage of the amount borrowed.

Put simply, interest is the payment made for the use of money, and it is often

called the price of money. For example, you may deposit $2,000

in a savings account at your local bank, where the rate of interest is 4% per year.

At the end of the year, the bank will have paid $80 in interest into your account.

Your deposit will be worth $2,080.

Textbooks often speak of the interest rate.

But in today's complex financial system, there

is really a vast array of interest rates.

There are three major reasons why interest rates differ.

First, there is the term or maturity of the loan.

This refers to the length of time until it must be paid off.

This can range from overnight loans to up to 30 years or more for a home mortgage.

In general, longer term loans command

a higher interest rate because lenders are

willing to sacrifice quick access to their funds.

Only if they can increase their return or yield.

Second, there is the degree of risk.

Some loans, such as the securities of the U.S. government, are virtually riskless.

In fact, the interest rate on U.S.

government securities is often called the riskless rate.

In contrast, very risky

investments, which bare a significant chance of default or

non-payment might include the securities of businesses close to bankruptcy.

Cities with shrinking tax bases, or countries

with large overseas debt, and unstable political systems.

These riskier investments might pay 1, 2, or even

5% or more per year above the risk less rate.

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Third, there is the issue of liquidity.

An asset is said to be liquid if it can

be converted into cash quickly with little loss in value.

In contrast, because of the higher risk and difficulty of extracting a borrowers

investment, illiquid assets, or loans usually command higher interest rates.

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These fluctuations underscore the need to understand the difference between

real and nominal rates.

The nominal interest rate measures the yield

in dollars per year per dollar investment.

But as with nominal GDP, inflation can

make the dollar a rubbery and distorted yardstick.

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That's why economists also compute the real interest rate.

It corrects for inflation and is simply calculated

as the nominal interest rate minus the rate

of inflation. Thus, if the nominal interest rate is 8%

per year, and the inflation rate is 3% per year, what's the real interest rate?

That's right, it's 5%.

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This table helps emphazise why the distinction between

nominal and real interest rates is so important.

Look at the years in the table, such as 1973 through

1975 when investors were actually earning a negitive rate of real interest.

Even though nominal rates were high.

That's why, as an investor, it's important for you

to focus on your real return, not your nominal return.