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Affects of real interest rates on the value of money Essay

Real Interest rates are critical in determining the long-term value of money. Real interest rates are primarily dependent upon two factors – the nominal interest rate and the rate of inflation. Therefore, there are several ways to look at real interest rates which have value for companies and industries in general. It is critically important for companies to attempt to evaluate the real interest rate on both investments and borrowings. The difficulty lies in estimating the rate of inflation over the length of the loan or the investment.

Inflation is not known, and based on the industry, fluctuations in inflation can cause varying effects on the value of money. First, an example. If money is invested with a fixed rate of return of 10% for 5 years, and the inflation rate rises, the actual value of the money decreases over time. Therefore, in the preceding example, although the amount the company has is growing, the rate of inflation in years 2 and 5 show that the value of the money is negative, meaning that inflation has removed the value of the interest gained.

In a manufacturing or commercial industry, it is important for businesses to invest their money in ventures that will

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return at a higher rate than that of inflation in order to see return on the investment. Even when considering the purchase of machinery and other durable goods, the rate of inflation can destroy the value of the initial purchase price. In data provided by freelunch. com, we can trace the real interest rate over the past 5 years, month-by-month. The following table shows the rate of the Federal Reserve and the Inflation rate, the difference is the Real Interest Rate.

As can be seen, the Fed closely manages the Federal Interest Rate to keep the Real Interest Rate above the rate of inflation. However, if money is set with a fixed return rate, then inflation can substantially decrease the value of the money borrowed. The company must also make the decision is their money is greater value now or later. They must make the choice to place money into an investment. If the company decides to invest money, it indicates that they think the money will have greater value in the future than it does at the present time.

Additionally, when the real rate of interest is high, it indicates that companies can make significant income from investing money, and money will flow from consumption into savings programs to take advantage of the high rate of return. In 2003 the Fed lowered the nominal interest rate to encourage companies to invest internally to boost the economic sector. Once the proper investment was recorded to have happened, the Fed raised the interest rate again, thus moving money into the investment markets.

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