Interest rates work like prices in that they allocate the scarce resource called money to it's alternative uses, consumption today versus tomorrow. Not only that but the real "price" of money takes into acount both the number we see and what we expect to happen to the value of money over time (inflation). Thus Real Interest Rate = Nominal Interest Rate - Inflation.
Related to this is the difference in real rates of return (or rates of expected interest) among different types of investments: stocks vs bonds vs CDs vs Mutual funds vs real estate etc. Generally the more volatile (or risky) an investment the higher the average rate of return. Additionally, investments (ie bonds) that are longer term have higher rates of return. Why? to compensate for the increased uncertainty and risk over the longer period. So, for example 30 yr bonds will have higher yields (interest rates) than 5 yr bonds.
Finally, to figure out what money in the future is worth today or what money today will be worth in the future you need to know how to complete Present Value and Future Value calculations. You need to memorize the formula to do so, using annual compounding only. Of course these calculations to know the amount of money, expected rates of growth (to get future value) or discount rates (to get present value), and the number of years.
Related to this is the difference in real rates of return (or rates of expected interest) among different types of investments: stocks vs bonds vs CDs vs Mutual funds vs real estate etc. Generally the more volatile (or risky) an investment the higher the average rate of return. Additionally, investments (ie bonds) that are longer term have higher rates of return. Why? to compensate for the increased uncertainty and risk over the longer period. So, for example 30 yr bonds will have higher yields (interest rates) than 5 yr bonds.
Finally, to figure out what money in the future is worth today or what money today will be worth in the future you need to know how to complete Present Value and Future Value calculations. You need to memorize the formula to do so, using annual compounding only. Of course these calculations to know the amount of money, expected rates of growth (to get future value) or discount rates (to get present value), and the number of years.
For next time read BE 341-352 completing the standard journal entry and answering this question:
- Give an example of moral hazard or adverse selection here at the air force academy.
Last time was a check.
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