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The Determinants of the Interest Rate Inflation and Interest Rates The Cyclical Movement of Interest Rates

2

The Determinants of theInterest Rate

Changes in the interest rate influence the behavior of net borrowers and net lenders.

In the market for loanable funds, supply and demand are the key to determining interest rates in equilibrium.

利率的变化会影响借方和贷方的行为，但最终的均衡利率是由借方的需求和贷方的供给共同决定。

3

Interest rate: stocks and flows

In chapter 3, interest rate is determined by the demand and supply of money. The supply of and demand for money are both measured at a point in time and refer to actual stocks.

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stocks and flows

When there is a change in a stock measured at different times , a flow has occurred, that is ,a flow over time results in a change in a stock.

A theory stated in stocks can always be reformulated in terms of flows and vice versa.

Loanable funds model deals with flows of loanable funds over time.

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On the borrower side

The demand for loanable funds originates from household, business, government, and foreign net borrowers

可贷资金需求：来自于个人、企业、政府或国外部门的借款需求。they are spending more than their current income

Net borrowers are willing to borrow more at lower interest rates, ceteris paribusthe demand for loanable funds will be downward

sloping

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On the lender side

The total supply of loanable funds originates from two sources:

可贷资金供给：可供借贷的资金来自两方面： （ 1 ）个人、企业、政府或国外贷方 （ 2 ）联储的准备金供给

household, business, government, and foreign net lenders they spend less than their current income

the Fed supplies reserves to the financial system that lead to increases

in the growth rate of money and loansassume that this is fixed (for now)

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Net lenders are willing to supply more funds at higher interest ratesthe supply of loanable funds will be upward

sloping

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The Determinants of theInterest Rate

The equilibrium interest rate occurs where the quantity of funds supplied is equal to the quantity of funds demanded

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The Supply of and Demand for Funds

Interest Rate

(Percent)

Loanable Funds (in Billions)

Demand

Supply

$500

E16

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Changes in the Demand for Loanable Funds

Movements in GDP are a major determinant of shifts in the demand for fundswhen GDP rises, firms and households are

more willing and able to borrow

Another factor that affects the demand for loanable funds is an increase in the expected productivity of capital investments

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A Shift in the Demand for Funds

Interest Rate

(Percent)

Loanable Funds (in Billions)

DD

$500

E1

Supply

6

$600

8 E2

D’D’

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Changes in the Supply of Loanable Funds

One of the factors affecting the supply of funds is monetary policythe Fed’s ability to alter the growth rate of

money in the economy means that it can have a direct effect on the cost and availability of funds

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A Shift in the Supply of Funds

Interest Rate

(Percent)

Loanable Funds (in Billions)

Demand

$500

E1

SS

6

$550

4 E2

S’S’

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The Determinants of theInterest Rate

The determinants of interest rates can be summarized as follows

i = f (Y+, M -)the interest rate is a positive function of income

or GDP (Y) and a negative function of the money supply (M)an increase in Y increases the demand for fundsan increase in M increases the supply of funds

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Inflation and Interest Rates

Lenders are concerned with two thingsnominal interest

how many dollars will be received in the future in return for lending now

inflation the real purchasing power the funds will be worth

upon repayment

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Inflation and Interest Rates

The market interest rate (the nominal interest rate 名义利率 ) is not an adequate measure of the real return on an interest-bearing asset

The appropriate measure is the real interest rate （实际利率）the return on the asset corrected for changes

in the purchasing power of moneythe nominal interest rate minus the expected

rate of inflation

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Inflation and Interest Rates

i = r + pe

The inflation premium （通货膨胀补偿） is the amount of nominal interest that will compensate a lender for the expected loss of purchasing power accompanying any inflationequal to the expected inflation rate (pe)

Nominal interest rates rise and fall as expected inflation rises and falls

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Example Suppose that the commercial paper rate is

5% and the current expected rate of inflation is 3%the expected real interest rate is 2%

If borrowers and lenders expect the inflation rate to be 6%, the expected real interest rate becomes -1%this drop in the real cost of borrowing and real

return on lending will increase the demand for funds and lower the supply of funds

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The Supply of and Demand for Funds

Interest Rate

(Percent)

Loanable Funds (in Billions)

DD

E1

SS

5

$500

E28

D’D’

S’S’

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The Determinants of theInterest Rate

We can now summarize the determinants of interest rates as follows

i = f (Y+, M -, pe +)the nominal interest rate is positively related to

the expected inflation rate

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The Cyclical Movement of Interest Rates

During a recession, income and GDP fall and the Fed may attempt to stabilize the economy by increasing the money supplyreduces the demand for fundsincreases the supply of fundsa drop in the inflation rate

The result is a decline in the interest rate

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The Cyclical Movement of Interest Rates

During an expansion, income and GDP rise and the Fed may attempt to slow the growth rate of the money supplyincreases the demand for fundsdecreases the supply of fundsinflation usually reaccelerates

The result is a rise in the interest rate

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Summary of Major Points

The interest rate is the return on lending today (spending in the future) and the cost of borrowing today (repaying in the future)the interest rate represents the time value of

money and specifies the terms under which one can trade present purchasing power for future purchasing power

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Summary of Major Points

Compounding answers the question: what is the future value of money lent today?it is the increase in the future value of funds

from earning interest on interest

Discounting answers the question: what is the present value of money to be received in the future?here again the interest rate links the present

with the future

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Summary of Major Points

A bond is a stream of future paymentsthe price of a bond will be equal to the present

value of the discounted future stream of incomewhen the interest rate changes, this present

value will change alsowhen the interest rate rises, the price of outstanding

bonds will fallwhen the interest rate fall, the price of outstanding

bonds will rise

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Summary of Major Points

Ceteris paribus, the quantity demanded of loanable funds is inversely related to the interest rate

Ceteris paribus, the quantity supplied of loanable funds is positively related to the interest rate

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Summary of Major Points

Changes in interest rates are the result of changes in the supply of and/or demand for fundsthe demand for funds is positively related to

income and positively related to anticipated increases in the productivity of capital investment

the supply of funds is positively related to the money supply

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Summary of Major Points

The nominal interest rate (i) is composed of a real interest rate (r) and an inflation premium reflecting the expected inflation rate (pe)

i = r + pe

The determinants of the interest rate can be summarized as

i = f (Y +, M -, pe +)

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Summary of Major Points

The consumer price index (CPI) measures changes in the cost of goods and services purchased by a typical urban consumer

The producer price index (PPI) measures the change in the cost of goods and services purchased by a typical producer

The inflation rate is generally measured by the percentage change in one of these price indexes

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Summary of Major Points

Interest rates tend to fluctuate procyclicallyduring a recession, income and GDP fallas an expansion takes hold, income and GDP

rise

A consol is a perpetual bond with no maturity datethe price of a consol is equal to the coupon

payment divided by the nominal interest rate