Interest rate

An interest rate is the rate at which interest is paid by a borrower (debtor)

for the use of money that they borrow from a lender (creditor).

The nominal interest

interest payable.

The nominal interest rate (or money interest rate) is the percentage
increase in money you pay the lender for the use of the money you
borrowed.

For instance, imagine that you borrowed $100 from your bank one year ago
at 8% interest on your loan. When you repay the loan, you must repay the
$100 you borrowed plus $8 in interesta total of $108.

The real interest rate measures the percentage increase in

purchasing power the lender receives when the borrower repays the loan with
interest.

In our earlier example, the lender earned 8% or $8 on the $100 loan.

However, because inflation was 5% over the same time period, the lender
actually earned only 3% in real purchasing power or $3 on the $100 loan.

Effects of inflation removed

real interest rate = nominal interest rate - expected inflation

rate

is the amount, in percentage terms, of

Difference between Nominal and Real Interest Rate

The real interest rate is the nominal rate of interest minus inflation. In the case of a loan, it is this real
interest that the lender receives as income. If the lender is receiving 8 percent from a loan and
inflation is 8 percent, then the real rate of interest is zero because nominal interest and inflation are
equal. A lender would have no net benefit from such a loan because inflation fully diminishes the
value of the loan's profit.

It matters because nominal rates dont tell the whole story for your
investment returns or the economy.

To really understand whats happening with your money, you need to look at
real rates, too.

Relationship between Interest Rates and Inflation.

Inflation and interest rates are linked, and frequently referenced in

macroeconomics.

Inflation refers to the rate at which prices for goods and services rises.

It's usually measured as an annual percentage, just like interest rates

Also, in a healthy economy, wages rise at the same rate as prices.

As interest rates are increased, consumers tend to have less money to spend.
With less
spending, the economy slows and inflation decreases.

Inflation and its causes.

Measure Inflation

Number of goods that represent the economy are put together,

this is called a market basket

Cost of this basket is compared over time

Results in a price index

Cost of the market basket today as a percentage of the cost of

that identical basket in the starting year
Wholesale Price Index

WPI it is the price of a representative basket of wholesale goods

Used in government, banks, industry

Measures and tracks the changes in price of goods before retail level

Report monthly to show the average price changes of goods sold in bulk

Published by economic advisor, ministry of commerce & industry

Calculation

A consumer price index (CPI) measures changes in the price

level of a market basket of consumer goods and services purchased by
households.

The annual percentage change in a CPI is used as a measure of inflation.

Sometimes referred to as "headline inflation."

Calculated by taking price changes for each item in the basket of goods and
averaging them

Goods are weighted according to their importance

CPI is one of the most frequently used statistics for identifying periods of
inflation or deflation.

The calculation involved in the estimation of CPI is quite rigorous.

It gives an idea of the cost of living.

Why CPI and not WPI in India?

WPI captures price movements in a most comprehensive way.
WPI measures inflation at each stage of production whereas CPI
measures inflation only at the final stage of production.
CPI is based on the final prices of goods at the retail level.
Hence, many nations have already shifted to using CPI.

The conceptual case for moving to CPI rests on two points. First, WPI
excludes prices of services such as education, healthcare, and rents.
Conversely, the new CPI measure assigns nearly 36%weightage on
services and includes price changes in housing, education,
healthcare, transport and communication, personal care and
entertainment. CPI, therefore, is a better reflector of demand side
pressures in the economy, than wholesale prices.
Second, WPI assigns nearly 15% and 10.7% weightage for the fuel
group and metal and metal products group, respectively. Any sharp

movements in international prices of fuels and metals, therefore, lead

to sharp changes in WPI. This was visible in calendar year 2009 when
WPI inflation fell below
2%.During the same year, CPI (industrial
workers) inflation averaged nearly 11%.

Such differences in coverage and weightage in WPI and CPI at times

lead to diverging trends and make it difficult to gauge the underlying
inflationary pressures.