[MUSIC] Up to this point in the course, I've actually talked quite a bit about of interest rates and how they affect investment. But I have not really defined the term. Let's do that formally now. [MUSIC] Put simply, interest is the payment made for the use of money. And it is often called the price of money. [MUSIC] As for the rate of interest, in this key definition, the interest rate is defined as the amount of interest paid per unit of time expressed as a percentage of the amount borrowed. And you repeat that, the interest rate is the amount of interest paid per unit of time expressed as a percentage of the amount borrowed. For example, you made deposit $2,000 in a savings account at your local bank with the rate of interest is 4% per year. at the end of the year the bank will pay $80 of interest in to your account, and your deposit will be worth $2, 080. [MUSIC] Economics textbooks often speak of the interest rates. But in today's complex financial systems, there's really a vast array of interest rates that are associated with an equally vast array of long types and instruments. For example, there are bonds issued by the government, as well as by the private sector. Banks offer so-called lines of credit, and a variety of banks and lending institutions offer everything from construction loans to home mortgages. Each of these types of lending instruments specifies the rate of interest to be paid, as well as the term of the loan or so-called loan maturity. For example, a construction loan may be no more than 24 months, but a home mortgage may be as many as 30 years. While banks lend to other banks often on an overnight basis. Each of these types of lending instruments also specify whether the interest rate charged is a fixed rate over the term of the loan, or an adjustable rate. For example, many mortgages are issued at a fixed rate, while the interest rate on credit card debt can jump if you fail to make your payments on time. Despite the dizzying array of lending instruments in the marketplace, we can identify at least three major reasons why interest rates differ. [MUSIC] In general, the longer the term of the loan, the higher the interest rate will be holding other things constant. Such longer term loans command a higher interest rate, because lenders will only be willing to sacrifice quick access to your funds. The liquidity, if they can increase their return or real on the loan. [MUSIC] A second reason why interest rates differ is the degree of loan risk, where one of the biggest risks is the risk of default. That is, the borrower may not be able to make payments on the loan. The loan goes into default, and the lender loses some or all of his or her money. At one end of the loan risk spectrum are the bonds and securities issued by big and stable governments, like that of Canada or Europe. These types of bonds and securities offer little or no risk of default, because of the size and stability of the government. In contrast very risky investments, which have a very significant chance of the default for none payment. Might include the security use of anything, businesses close to bankruptcy and cities with shrinking tax bases, to countries with large overseas debts or unstable political assistance. The key point here is this, the greater the loan risk, the higher will be the interest rate. [MUSIC] A third reason for differing interest rates has to do with the degree of liquidity I previously talked about. So how do you think interest rates would be affected by the liquidity of an asset? Take a minute to jot down your answer [INAUDIBLE]. [MUSIC] Remember here that an asset is said to be liquid, if it can be converted into cash quickly with little loss in value. In contrast with an illiquid asset, it can be very difficult to readily convert the asset's value into cash. And that's why the more illiquid the asset, the higher the interest rate one must pay. [MUSIC] To end this module, let's clearly distinguish between the real and nominal rate of interest. In fact, we have talked about the importance of adjusting for inflation when we defined the real versus nominal gross domestic product. In this case and in this key definition, phenomenal interest rate measures the yield in dollars per year per dollar of investment. [MUSIC]. The real interest rate corrects for inflation and it is simply calculated as the nominal interest rate minus the rate of inflation. Thus, if the nominal interest rate is 8% per year and the inflation rate is 3% per year, what's the real interest rate? And how about if the nominal interest rate is 8% per year, but inflation is 10%. Please quickly jot down your answers before moving on. [MUSIC] If the nominal interest rate is 8% and the inflation rate is 3%, the real interest rate must be 5%. So you're still earning a positive return. However, if inflation is running to 10%, you're only earning an 8% nominal return, you're actually losing money on your investment with the negative 2% return. And I included this second example of negative interest rates to underscore this key point. In periods of rapid inflation, it can be very difficult for investors to earn a positive return on investment like bonds. And that's just one more reason to be aware of the macroeconomic environment as a business executive or investor, so you can avoid situations like that. The watchword here is, always focus on your real return, not your nominal return. And with that piece of macroeconomic wisdom dispensed, let's move on to the next module. When you're ready, and talk about the kinds and functions of money. [MUSIC]
