Interest Rate - Mathematical Note

Mathematical Note

Because interest and inflation are generally given as percentage increases, the formulae above are (linear) approximations.

For instance,

is only approximate. In reality, the relationship is

so

The two approximations, eliminating higher order terms, are:

\begin{align} (1+x)(1+y) &= 1+x+y+xy &&\approx 1+x+y\\ \frac{1}{1+x} &= 1-x+x^2-x^3+\cdots &&\approx 1-x \end{align}

The formulae in this article are exact if logarithms of indices are used in place of rates.

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