Lecture Issues in economics today - Chapter 4

When you finish this chapter, you should: Define the key terms of economics and opportunity cost and understand how a production possibilities frontier exemplifies the trade-offs that exist in life, distinguish between increasing and constant opportunity cost and understand why each might happen in the real world, analyze an argument by thinking economically, while recognizing and avoiding logical traps.
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Lecture Issues in economics today - Chapter 4 Chapter 4 Interest Rates and Present Value McGrawHill/Irwin ©2002TheMcGrawHillCompanies,Inc.,AllRightsReserved. Chapter Outline • Interest Rates • Present Value McGrawHill/Irwin ©2002TheMcGrawHillCompanies,Inc.,AllRightsReserved. Interest Rates The Market for Money McGrawHill/Irwin ©2002TheMcGrawHillCompanies,Inc.,AllRightsReserved. Interest Rate • The interest rate is the percentage, usually expressed in annual terms, of a balance that is paid by a borrower to a lender that is in addition to the original amount borrowed or lent. McGrawHill/Irwin ©2002TheMcGrawHillCompanies,Inc.,AllRightsReserved. Figure 1 The Market for Money Interest Supply rate(r) r* Demand $* Money($) Borrowed/SavedMcGrawHill/Irwin ©2002TheMcGrawHillCompanies,Inc.,AllRightsReserved. Nominal vs. Real Interest Rates • Nominal Interest Rate: the advertised rate of interest • Real Interest Rate: the rate of interest after inflation expectations are accounted for; the compensation for waiting on consumption McGrawHill/Irwin ©2002TheMcGrawHillCompanies,Inc.,AllRightsReserved. Present Value • Present Value is the interest adjusted value of future payment streams. • Mathematically, the present value of a payment is =(payment)/(1+r)n Where r is the interest rate n is the number of years until the payment is received/made. McGrawHill/Irwin ©2002TheMcGrawHillCompanies,Inc.,AllRightsReserved. The Amount Payable for Every Dollar Borrowed (For several interest rates and loan durations) Interest 20% 10% 5% 2% 1% rate -> Years 30 237.38 17.45 4.32 1.81 1.35 10 6.19 2.59 1.63 1.22 1.10 5 2.49 1.61 1.28 1.10 1.05 1 1.20 1.10 1.05 1.02 1.01 McGrawHill/Irwin ©2002TheMcGrawHillCompanies,Inc.,AllRightsReserved. Examples From This Table • If you borrow $1 and promise to pay it back in 5 years at 5% interest you will owe $1.28 which is the original $1 plus 28 cents in interest. • If you borrow $1 and promise to pay it back in 30 years at 20% interest you will owe $237.38 which is the original $1 plus $236.38 in interest. McGrawHill/Irwin ©2002TheMcGrawHillCompanies,Inc.,AllRightsReserved. Mortgages, Car Payments, and other Multiple-Payment Examples • Mortgages are loans taken out to buy homes. Typically you borrow a large sum of money and promise to pay it back in even amounts each month for 10, 15, or 30 years. • Car loans are similar to mortgages in that you borrow a large sum but the loan duration is usually two to six years. McGrawHill/Irwin ©2002TheMcGrawHillCompanies,Inc.,AllRightsReserved. A Multiple Year Example Supposeyoupay$100forthefirst5yearsthenreceive$100forthe next7years.Thepresentvalueofthecanbedepictedinthepicture below.Forinstancethepresentvalueofthe$100paidinthefifth yearis$100/(1.10)4or$68.30. McGrawHill/Irwin ©2002TheMcGrawHillCompanies,Inc.,AllRightsReserved. Monthly Payments Required on per $1000 of loan (For Several Interest Rates and Loan Durations) Interest 20% 10% 5% 2% 1% rate -> Years 30 16.71 8.78 5.37 3.70 3.22 10 19.33 13.22 10.61 9.20 8.76 5 26.49 21.25 18.87 17.53 17.09 1 92.63 87.92 85.61 84.24 83.79 McGrawHill/Irwin ©200 ...