CHAPTER THREE

INTEREST RATES IN THE FINANCIAL SYSTEM

What is interest rate?
 is a rate of return paid by a borrower of funds to a lender of the fund.
 a price paid by a borrower for a service, the right to use the funds for a specified period
Interest rates also vary depending on whether you are borrowing or lending.
 There is a difference between the interest rate at which banks are prepared to lend (the
offer rate) and the rate they are willing to pay to attract deposits (the bid rate).
 There is also a difference between selling and buying rates in international money
markets.

They help us evaluate and compare different investments or loans over time. However, if we
compare financial data over time, we have to consider the effects of inflation.

This is why we distinguish between two different types of interest rates: the NOMINAL
INTEREST RATE and THE REAL INTEREST RATE.

Nominal Interest Rate

 Describes the interest rate without any correction for the effects of inflation.
 the advertised or stated interest rates we see on bonds, loans or bank accounts are usually
a nominal one.
 Shows you the actual price you are paid (or have to pay) if you lend (or borrow) money.
Simply, it shows you by how much the amount of money you have in your bank account
increases over time.
 example, let’s assume you deposit 10’000 Birr with 7% interest,

Real Interest Rate

 interest rate adjusted to remove the effects of inflation
 Shows you by how much the actual purchasing power of the money you have in your bank
account increases over time.
 Describes the real yield of lending money or the real cost of borrowing money.

 Calculating = take the nominal interest rate and subtract the inflation rate. This equation
is also referred to as the Fisher equation. Real Interest Rate = Nominal Interest Rate –
Inflation

3.2 THEORIES OF INTEREST

 Classical Theory
 The loan able funds theory
 Liquidity preference theory

1. CLASSICAL THEORY
 This theory is also regarded as savings and investment theory of rate of interest.
 the rate of interest is determined by the interaction of savings and investment.