Capital Markets Chapter 24

Nominal and Real Interest Rates

•Nominal return represents how much money you will receive after 1 year for giving up 1 dollar of money today

•Real return represents how many goods you can buy if you give up the opportunity to buy 1 good today.

•Nominal interest rate is money interest rate. Real interest rate is goods interest rate.

Real Interest Rate

11

$1 $11

$1

11

1

t+1t

t+1

t t

tt t t t

t

i iP 1r

PP P

ir r i

•The real interest rate on the loan is defined as the future goods received relative to current goods foregone

Measuring the Real Interest Rate

• Long-term1. Use the yield on inflation protected

securities. • Short-term1. Use nominal interest minus consensus

inflation forecast2. Use nominal interest rate minus your own

inflation forecast

TIPS Bond

•The US Treasury offers bonds whose principal and coupon payments increase with the inflation rate.

•Investors are paid off in terms of real purchasing power.

•Yield is equivalent to a real interest rate.

Additional Information from U.S. Treasury

Real & Nominal Interest Rates

π10 Year Forecast

http://research.stlouisfed.org/fred2/categories/22

Loanable Funds Market

Loanable Funds Market•Consider the financial market at its broadest

and most abstract. ▫an amalgamation of the bond market and the

lending market (banks, etc.)•Map the relationship between the interest rate

and the quantity of funds that are lent.▫Supply curve represents the behavior of savers &

lenders▫Demand curve represents the behavior of

borrowers

Supply Curve: Loanable Funds

•Why does the supply curve slope up?▫When real interest rates offered by banks are

high, savers are rewarded with more future consumption and are likely to be induced to save more.

▫Caveat: If some savers are setting a target for their level of wealth at retirement, a higher interest rate reduces the amount they need to save. For this reason, many economists believe saving

curve is very inelastic.

Demand Curve: Loanable Funds•Why does the demand curve slope down?

▫Firms borrow to finance investment projects. If the return on investment falls below the interest rate, the project is not worthwhile. The higher the interest rate, the fewer projects fall below the hurdle.

▫Households borrow to finance housing. The higher are interest rates, the smaller is the house that the householders can buy with a mortgage payment that they can afford.

Globalization and the Loanable Funds Market

•Even ten years ago, we might have thought of the loanable funds market as being national in nature – especially for large economies. These days it appears that even the USA is part of a single global market. [China possible exception]

•Only very large changes in large countries or international trends will have an impact on real interest rates.

Competitive Market Equilibrium:Loanable Funds Market (Geometry)

SLFDLF

LF

r*

LF*

r

Ex. Investment Boom in Emerging MarketsMcKinsey Report

SLFDLF

LF

r*

LF*

r

r**

DLF'

LF**

1

2

Ex. US Consumers become thriftier

DLF

LF

r*

LF*

r

LF**

SLF'

r**

1

2

SLF

Savings

•We divide savings into 2 parts:

SPrivate Private Saving(Household + Business Saving)

+SPublic Public Saving/Government Saving(Budget Surplus)

= S National Saving

Public Savings is part of the supply of loanable funds if positive and part of demand for loanable funds if negative (as usual).

Government Surplus

•Government surplus is gap between govt revenue and spending and can be positive or negative.

•If net positive, it adds to the supply of loanable funds.

•If net negative, it adds to the demand for loanable funds.

Example: Government strikes a deal to raise taxes and cut spending

LF

r*

LF*

r

r**

LF**

1

2

DLFSLF SLF'

Ex.Japanese Government runs a deficitBudget Plan

LF

r*

LF*

r

r**

LF**

1

2

DLF DLF' SLF

National Economy

• How do national economies relate to the global financial market?

1. Countries will face an external interest rate, rW, unaffected by national savings or investment.

2. International capital flows will make up the gap between savings and investment.

http://www.bea.gov/national/nipaweb/SelectTable.asp?Selected=Y

Competitive Market Equilibrium:Loanable Funds Market

LF

r*

LF*

r

KA

DLF SLF

Investment Boom[r Doesn’t Rise, Gap made up by Capital Inflows]

LF

rW

LF*

r

LF**

12KA

DLF DLF' SLF

Consumers become less thrifty(r does not fall, gap made up by capital inflows)

LF

rW

r

1

2 KA

DLF SLF

SLF'

Savings Glut

•Theory put forth by Fed Chairman explaining the U.S. trade deficit: Washington Post Article

World Interest Rate Falls(Global Economy)

LF

rW

r

1

2rW' 2

DLF

SLF

Net Capital Outflows = ‘Goods & Income Outflows•Private Savings: Y + NFI -Tax – C•Public Savings: Tax – G•National Savings: S = Y+ NFI – C – G•Capital Outflows: -KA = S – I

S-I = NFI + (Y – C – G – I) = NFI +NX

http://www.bea.gov/national/nipaweb/SelectTable.asp?Selected=Y

US Current Account

-7.00%

-6.00%

-5.00%

-4.00%

-3.00%

-2.00%

-1.00%

0.00%

1.00%

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

NX NFI CA

Ex Ante Rate and the Fisher Effect

1EA FORECAST

t t ti r

•Savings and investment decisions must be made before future inflation is known so they must be made on the basis of an ex ante (predicted) real interest rate.

•Fisher Hypothesis: Ex ante real interest rate is determined by forces in the financial market. Money interest rate is just the real ex ante rate plus the market’s consensus forecast of inflation.

Great Inflation of the 1970’sUS Inflation Rates & Interest Rates

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00M

ar-5

5

Mar

-58

Mar

-61

Mar

-64

Mar

-67

Mar

-70

Mar

-73

Mar

-76

Mar

-79

Mar

-82

Mar

-85

Mar

-88

Mar

-91

Mar

-94

Mar

-97

Mar

-00

Mar

-03

%

Interest Rates

Inflation

Source: St. Louis Federal Reserve http://research.stlouisfed.org/fred2/

Great Inflation Download

Fisher Effect: OECD Economies Great Inflation of 1970’s

0

2

4

6

8

10

12

14

16

18

20

0 2 4 6 8 10 12 14 16 18

Average Inflation 1970-1984

Inte

rest

Rat

es-1

984

Loanable Funds MarketFisher Effect

LF

r*

LF*

1Et

1Et

i*

DLF SLF

•We can also examine the ex post real return on a loan as the money interest rate less the actual outcome for inflation.

•The gap between actual and forecast inflation determines the gap between the ex post (actual) and ex ante (forecast) return.

Ex Ante vs. Ex post

1ExP ACTUAL

t t tr i

1 1ExP ExA FORECAST ACTUAL

t t t tr r

Unexpected Inflation Winners and Losers

▫Higher than expected inflation means ex post real rates are lower than ex ante. Borrowers are winners/lenders are losers.

▫Lower than expected inflation means ex post real rates are higher than ex ante. Lenders are winners/borrowers are losers.

Inflation Risk

•When inflation is variable, lenders will demand some premium for inflation risk. This will put cost on borrowers.

•High inflation rates tend to be associated with unpredictable inflation.

Learning Outcome

•Calculate the relationship between inflation, expected inflation, interest rates and real interest rates.

•Use the Loanable Funds model to analyze the effects of external events on savings, investment, and real interest rates in capital markets.