Interest Rates

Lesson

Interest rates are the cost of borrowing money or the return on investment for lending money. They play a crucial role in determining the cost of capital for businesses and the return on investment for investors.

Practice Question #1

What is the primary difference between the nominal interest rate and the real interest rate?

Terms

Interest Rate:

The cost of borrowing money or the return on investment for lending money.

Nominal Interest Rate:

The interest rate before taking inflation into account.

Real Interest Rate:

The interest rate after adjusting for inflation.

Risk-Free Rate:

The interest rate on a risk-free investment, typically a government bond.

Prime Rate:

The interest rate that banks charge their most creditworthy customers.

Federal Funds Rate:

The interest rate at which banks lend reserve balances to other banks overnight.

Discount Rate:

The interest rate charged by the Federal Reserve to banks for short-term loans.

Practice Question #2

Which of the following best describes the relationship between interest rates and bond prices?

Historical Example

In the early 1980s, interest rates in the United States reached record highs, with the Federal Funds Rate peaking at over 20%. This was due to the Federal Reserve's efforts to combat high inflation by tightening monetary policy. The high interest rates led to a recession but ultimately helped bring inflation under control.

Practice Question #3

What is the primary purpose of the Federal Reserve raising interest rates?

Real-World Example

In recent years, interest rates have been historically low due to central banks' efforts to stimulate economic growth following the global financial crisis. This has led to lower borrowing costs for businesses and consumers and lower returns on investment for savers and investors.