Interest Rates: Inflation and Loans

Interest Rates: Inflation and Loans

23 April 2014

Interest Rates: Inflation and Loans

23 April 2014

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Last Time

On Monday we discussed compound interest and saw that money can grow very large given enough time, or a high enough interest rate. We'll see how this is relevant for discussing loans. Home loans, which often run for 30 years, are over a long enough period of time that rates of interest are very significant. We'll see why.

Interest Rates: Inflation and Loans

23 April 2014

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Clicker Question

My grandparents bought a house in San Francisco for $6,000. If I offered the current owners $12,000 for the house, which response below do you think would most represent their feelings about the offer?

A Very happy B Satisfied C Unhappy D Disgusted E Would call the police on me

Interest Rates: Inflation and Loans

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Answer

While I don't know if they'd call the cops, they certainly would not be interested in the offer. Why not? Because inflation affects house prices over a long period of time. The $6,000 price was over 80 years ago.

Interest Rates: Inflation and Loans

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Inflation

The mathematics of inflation on the value of money is similar to that of compound interest.

If the inflation rate averages 5% per year, an item that cost $100 today would be expected to cost $100 ? 1.05 = $105 in one year.

How much would it be expected to cost in 2 years?

It would be 105% of $105, or $105 ? 1.05 = $100 ? 1.05 ? 1.05 = $100 ? 1.052

which is $110.25.

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