Distinguish between nominal and real interest rates. Why are nominal interest rates often higher in third world countries? Also, define the effective interest rate. Provide three examples.
An interest rate is an amount charged by a lender to a borrower for the use of assets like vehicles, cash, and consumer goods. Typically, the interest rate is expressed as a percentage of the principal and is noted on an annual percentage rate (APR). The formulas for calculating interest rates are simple and compounding methods whose use depends on a variety of factors like who is lending. The available types of interest rates are several, and major economic factors distinguish all. This paper distinguishes the nominal and real types of interest rates. The paper also explains why interest rates are often higher in third world countries. Moreover, the paper defines the effective interest rate.
The nominal interest rate does not take inflation into account and it the rate quoted on loans and bonds. For example, if the nominal rate of a $ 100 loan is 5%, the borrower pays $5 for every such loan. A real interest rate takes inflation into account, and it usually adjusts for inflation to give the real rate of a loan or a bond (Engel, 2016). For instance, for a housing loan of $ 200000 at the rate of 4% and inflation of 2%, the borrower will pay a real interest of 2% (Engel, 2016). Nominal interest rates in the third world countries are usually high because the interest rate is majorly used as a technique to shave off currency collapses sharply. Also, third world countries are likely unable to pay their debts; thus they pay higher nominal interest in order to make up for the risk. An effective interest rate is also referred to as the market interest rate, and it is the true interest earned. For instance, a $ 500 bond that promises a 4% interest is said to have a nominal interest of 4% (Engel, 2016).
Engel, C. (2016). Exchange rates, interest rates, and the risk premium. American Economic Review, 106(2), 436-74.
by EssayRoyal, Dec. 10, 2019, 5:01 p.m.