Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed.
PART 8 The Data of Macroeconomics
Chapter 24 of 36 Measuring The Cost of Living
Section 12 of 15
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The interest rate concept involves comparing money value at different time points.
When you deposit savings in a bank account
· you give the bank money now
· the bank pays you interest and your deposit amount in the future
Conversely, when you borrow from a bank
· you get money from the bank now
· you pay to the bank interest and your loan amount in the future
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To understand the transaction between you and the bank, it is essential to acknowledge
· future dollars will have a different value from today's dollars
· the money value must be corrected for inflation
Suppose Sally Saver deposits $1000 in a bank account that pays an annual 10 percent interest rate.
A year later, after she has made $100 interest, she withdraws the $1100.
Is Sally $100 richer than when she made the deposit a year earlier?
She has $100 more than before.
But she doesn’t care about the amount of money itself, she cares about what she can buy with her money.
If prices have risen each dollar now buys less than it did a year ago.
A year ago when she made the bank deposit a CD at the local music store cost $10.
Her deposit of $1000 was equivalent to the value of 100 CDs.
Now, a year later, with interest she has $1100
How many CDs can she can buy now with $1100 depends on the current CD price, which may be higher now because of inflation.
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