What the rise in prices means for interest costs can most easily be explained by first looking at savings. If you save USD 100 from one year to the next to seven percent interest, you will receive an income of USD 7 to defer the use of the money from today to next year.
Did you know that price increases reduce the value of debt and interest costs?
If you assume that the price increase over the same year will be five percent, you must have five percent interest only to maintain the purchasing power of 100 USD.
In other words, you need USD 105 to be able to buy the same as the year before. Only the interest rate beyond this, in this case, two percent, or two USD, is the actual compensation for saving. This is what is called the real interest rate.
The increase is five percent, the price increase means that the real value of the loan is reduced
Of the total interest cost of 15 percent, the five percent increase is actually a form of savings, not interest expense. Therefore, in order to arrive at the interest cost, the price increase is deducted. In the example, the real interest rate is ten percent.
Here is another example of the price increase:
For a given interest rate, the higher the interest rate, the lower the price increase. The annual price increase was over ten percent in the early 1980s. In 1992 the price increase will be about two and a half percent, while in 1993 it was expected to fall to two percent.