| The time value of money | | | | Compound interest arises where interest is left in an |
| When lending (and borrowing) money, the timing of | | | | investment and itself then earns interest. For example, |
| payments of interest and return of capital has a | | | | doubling your money in such an investment takes: |
| significant effect on the interest rate. For interest | | | | - ten years at an interest rate of 5% |
| receipts it is called the AER (annual equivalent rate). In | | | | - seven years at 10% |
| the case of interest payments, such as for a | | | | - only five years at 15% |
| mortgage, it is called the APR (annual percentage rate) | | | | Another example comes from pensions. To achieve a |
| but is effectively the same thing. | | | | pension of £10,000 a year from the age of 65, a |
| When VAT on fuel was introduced in 1994, many | | | | man needs to contribute: |
| people paid in advance to save the 8% tax. Decisions | | | | - starting at age 30, £150 a month |
| like this should consider the effective rate of return on | | | | - starting at 40, £300 a month |
| the investment for the period. | | | | - starting at 50, £600 a month |
| Assuming your annual fuel bill is £100, what is the | | | | (For a woman it is 10% more in each case.) |
| effective rate of return? | | | | The effect of inflation |
| On the face of it, you might say 8%, because that is | | | | 'Real' rates of interest are the rates in excess of |
| what you have saved. | | | | inflation. Only these rates preserve the real value of |
| However, taking account of the time value of money, | | | | the capital. Usually they are in the region of 3%, |
| you need to allow for the fact that normally you pay | | | | whatever the actual rate. |
| monthly or quarterly. So, ignoring seasonal variations, | | | | However, since all interest is taxable, high interest rates |
| you would have only paid 7 1/2 months in advance on | | | | can result in negative real rates, so they are not |
| average. | | | | necessarily a good thing for taxpayers. |
| Consequently the effective AER (annual equivalent | | | | Definition of Quantity Theory of Money |
| rate) of 8% over 7 1/2 months is 13%. | | | | The proposition that a change in the growth rate of |
| Bearing in mind that it was effectively after tax, this | | | | the money supply brings an equal percentage change |
| was easily the best investment in 1994. | | | | in the inflation rate. |
| The effect of compound interest | | | | |