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Real and Nominal Interest Rate

As we read in Chapter 2, the contemporary position of the Roman Catholic Church regarding interest and the time value of money coincides with the position of modern economics and finance. In economics and finance, an individual who lends money for repayment at a later point in time expects to be compensated for the time value of money, or not having the ability to use that money (perhaps more productively) while it is lent, and particularly if it is not returned on time. In addition, owners of capital will want to be compensated for the risks of having less purchasing and investing power when the loan is repaid. These risks are:

Systemic risks. This includes the possibility that the borrower will default or will be unable to pay on the originally agreed-upon terms, or that collateral backing the loan will prove to be less valuable than estimated.

■ Regulatory risks. This includes taxation and changes in the law, which would prevent the lender from collecting on a loan or having to pay more in taxes on the amount repaid than originally estimated.

Inflation risks. This takes into account that the money repaid may not have as much buying power from the perspective of the lender as the money originally lent, and may include fluctuations in the value of the currencies involved.

Nominal interest rates include all three risk factors, plus the time value of the money itself. Real interest rates include only the systemic and regulatory risks and are meant to measure the time value of money. The real rate is equal to the nominal rate minus inflation and minus currency adjustment.

The real interest rate in an economy is often the rate of return on a riskfree investment, such as U.S. Treasury notes, minus an index of inflation, such as the Consumer Price Index (CPI) or GDP deflator. This is what we can call the interest rate decided by the Fed, as explained earlier, to run its fiat money monetary policy to the best of its ability. It must be stated that no specific money system is being advocated here because that is not the subject of this book or of the RF banking and finance system presented here. The subject of RF Monetary Discipline will be handled later in detail in a future book. All we want to achieve here is to familiarize the reader with the fact that the interest rate set by the Fed is in fact a monetary policy tool used by the Federal Reserve (the central bank of the U.S. government) and it is, in simple layman's terms, a mechanism by which the government represented in its Federal Reserve decides how much money to print or to withdraw from the market in order to achieve its policy goals about inflation, prices, and employment levels.

As suggested by the Taylor's equation, if all is kept constant and the FOMC wanted to increase the economic production, they would reduce the short-term interest rate on Fed Funds, and hence increase the economic growth rate. Of course, real-life situations are more sophisticated and involve many other factors, scenarios, permutations, and parameters. However, the fact remains that the interest rate that the Feds use is different from the one prohibited in the Judeo-Christian-Islamic Shari'aa law. It conceptually is a calibration tool for designing and implementing the government's monetary policy in a world that uses fiat money. This system, run by the FOMC, adjusts the amount and the rate of flow of money in or out of the fiat paper money system.

All those who believe in Judeo-Christian-Islamic values should focus on two important factors in our development of the RF banking and finance system. These factors are:

■ The use of the Commodity Indexation Discipline and approach (discussed in detail in Chapter 3) to ensure fair market pricing by disengaging the monetary effects of fiat (paper) money, as was discussed earlier and will be further developed later in the book.

■ The use of the Marking-to-Market Discipline to make certain that we are renting tangible and rentable assets at real market prices, which are obtained, live in the marketplace, and not the rental of fiat (paper) money, in order to ensure that we are investing prudently.

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