CHAPTER 4 THE LEVEL OF INTEREST RATES. Copyright© 2003 John Wiley and Sons, Inc. What are Interest Rates? Rental price for money. The time value of consumption

CHAPTER 4

THE LEVEL OF INTEREST RATES

Copyright© 2003 John Wiley and Sons, Inc.

What are Interest Rates?

Rental price for money.The time value of consumption.Opportunity cost.Expressed in terms of annual rates.As with any price, interest rates serve to allocate funds to alternative uses.


The Real Rate of Interest

There is a preference for "real" applications for savings such as consumption or real investment.

Real interest rate compensates for delayed consumption or giving up real investment opportunities.The higher the desire for consumption or real investment opportunities, the higher the real rate of interest.


The Real Rate of Interest, cont.

The real rate of interest is determined by the demand and supply for savings at a given point in time.

The real rate is the price needed to delay consumption of funds demanded for real investment.Upward shifts to the right (increases) in demand for desired real investment cause the real rate of interest to increase.If the supply of desired savings shifts upward (increases) to the right, the real rate of interest declines.


Determinants of theReal Rate of Interest


Loanable Funds Theory of Interest

The level of interest rates is determined by the supply and demand for loanable funds.

The real rate of interest is the long-term base rate of interest.Short-run supply/demand factors and financial market risks affect nominal interest rates.The quantity demanded of loanable funds, DL, is inversely related to the level of interest rates; the quantity supplied is directly related to interest rates.


Loanable Funds Theory of Interest, cont.

DSUs demand loanable funds for home building, plant/equipment, and inventory financing.The supply of loanable funds available for financial investment may come from decreasing money balances or past savings.


Supply/Demand Sources Notice that households, businesses, and governmental units are

both suppliers and demanders of loanable funds. During most periods, households are net suppliers of funds, whereas the federal government is almost always a net demander of funds.

Supply of Loanable Funds (SSU) Consumer savings Business savings (depreciation and retained earnings) State and local government budget surpluses Federal government budget surplus (if any) Federal Reserve increases the money supply (M) Demand for Loanable Funds (DSU) Consumer credit purchases Business investment Federal government budget deficits State and local government budget deficits


Loanable Funds Theory








Price Expectations andInterest Rates

Expected inflation, ex ante, is embodied in nominal interest rates -- The Fisher Effect.

Investors want compensation for expected decreases in the purchasing power of their wealth.If investors feel the prices of real goods will increase (inflation), it will take increased interest rates to encourage them to place their funds in financial assets.


Fisher Effect

The formula for the Fisher equation is:

inflation. of rate annual expected the

interest, of rate real ther

interest, of rate nominal observed the i

where

111

e

e

P

Pri


Fisher Effect, cont.From the Fisher equation, with a little algebra, we see that the nominal (contract) rate is:

From this equation we see that a lender gets compensated for:

rent on money loaned,compensation for loss of purchasing power on the principal,compensation for loss of purchasing power on the interest.

ee PrPri *


Fisher Effect, cont.

Contract rate example for: 1-year $1000 loan when the loan parties agree on a 3% rental rate for money and a 5% expected rate of inflation.

Items to pay Calculation AmountPrincipal $1,000.00Rent on money $1,000 x 3% $30.00PP loss on principal $1,000 x 5% $50.00PP loss on interest $1,000 x 3% x 5% $1.50Total Compensation $1,081.50


Fisher Effect (concluded)

The third term in the Fisher equation is approximately equal to zero, so it is dropped in many applications. The resulting equation is referred to as the approximate Fisher equation and is the following:

ePri


Price Expectations andInterest Rates

Actual realized ex-post rates of return reflect the impact of inflation on past investments or on investors.

r = i - Pa, where the annual "realized" rate of return from past securities purchases, r, equals the annual nominal rate minus the actual annual rate of inflation.With ever-increasing rates of inflation, investors' inflation premiums, Pe, may lag actual rates of inflation, Pa, yielding low or even negative actual real rates of return.


Exhibit 4.4 Nominal/Realized Rates


Interest Rate Changes and Changes in Inflation, Exhibit 4.5


Interest Rate Changes and Changes in Inflation (concluded)

What do we learn from the previous slide?

Interest rates change with changes in inflation.Short-term interest rates change more than long-term interest rates for a given change in inflation.

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CHAPTER 4 THE LEVEL OF INTEREST RATES. Copyright© 2003 John Wiley and Sons, Inc. What are Interest Rates? Rental price for money. The time value of consumption