Problem : Why do lenders require borrowers to pay interest?

Lenders require borrowers to pay interest for three reasons. First, when a person lends money, he or she is unable to use this money to fund purchases. Second, the borrower may default on the loan. Third, while the borrower has the money, inflation tends to reduce the real value, or purchasing power, of the loan.

Problem : How much would be due on a $20,000 loan at 6% interest after 3 years?

To calculate the value of a loan, add one to the interest rate, raise it to the number of years for the loan, and multiply it by the loan amount. So, the equation becomes $20,000 * (1.06 ^ 3) = $23820.32 total due after 3 years.

Problem : How does the nominal interest rate differ from the real interest rate?

The nominal interest rate does not take the effects of inflation into account, but the real interest rate does.

Problem : What is the equation that represents the real interest rate? What does this equation show?

The real interest rate is equal to the nominal interest rate minus the inflation rate. This shows the real price paid by the borrower for the loan given that inflation erodes the real value of money over time.

Problem : Explain the Fischer effect.

The Fischer effect is the point for point adjustment of the nominal interest rate to the real interest rate. The Fischer effect is derived from the quantity theory of money and is useful in interpreting the effects of increase in the money supply by the Fed on the nominal interest rate.

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