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