chapter 4 the level of interest rates copyright© 2012 john wiley & sons, inc
TRANSCRIPT
CHAPTER 4
THE LEVEL OF INTEREST RATES
Copyright© 2012 John Wiley & Sons, Inc.
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What are Interest Rates?
Rental price for money.Penalty to borrowers for consuming before earning.Reward to savers for postponing consumption.Expressed in terms of annual rates.As with any price, interest rates serve to allocate resources.
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The Real Rate of Interest
Producers seek financing for real assets. Expected ROI is upper limit on interest rate producers can pay for financing.
Savers require compensation for deferring consumption. Time value of consumption is lower limit on interest rate at which savers will provide financing.
Real rate occurs at equilibrium between desired real investment and desired saving.
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Determinants of the Real Rate of Interest
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Loanable Funds Theory
Supply of loanable funds—All sources of funds available to invest in financial claims
Demand for loanable funds—All uses of funds raised from issuing financial
claims
Equilibrium interest rate
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Supply of loanable funds—
All sources of funds available to invest in financial claims:
Consumer savings
Business savings
Government budget surpluses
Central Bank action
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Demand for Loanable Funds
All uses of funds raised from issuing financial claims:
Consumer credit purchases
Business investment
Government budget deficits
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Equilibrium Interest Rate
If competitive forces operate in financial sector, laws of supply and demand will bring rates into equilibrium.
Equilibrium is temporary or dynamic: Any force that shifts supply or demand will tend to change interest rates.
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Loanable Funds Theory
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Loanable Funds Theory
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Loanable Funds Theory
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Loanable Funds Theory
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Price Expectations and Interest Rates
Unanticipated inflation benefits borrowers at expense of lenders.
Lenders charge added interest to offset anticipated decreases in purchasing power.
Expected inflation is embodied in nominal interest rates: The Fisher Effect.
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Fisher Effect
The exact 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
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Fisher Effect, cont.
From the Fisher equation, we derive the nominal (contract) rate:
We see that a lender gets compensated for:rental of purchasing power,anticipated loss of purchasing power on the principal,anticipated loss of purchasing power on the interest.
ee PrPri *
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Fisher Effect: Example
1-year $1000 loan Parties agree on 3% rental rate for money and 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% 1.50
– Total Compensation $1,081.50
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Simplified Fisher Equation
The third term in the Fisher equation is negligible, so it is commonly dropped. The resulting equation is
ePri
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Expectations ex ante v. Experience ex post
Realized rates of return reflect impact of inflation on past investments.
r = i - Pa, where the "realized" rate of return from past transactions, r, equals the nominal rate minus the actual annual rate of inflation.
As inflation increases, expected inflation premiums, Pe, may lag actual rates of inflation, Pa, yielding low or even negative actual returns.
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Impact of Inflation under Loanable Funds Theory
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Interest Rate Movements and Inflation
Historically, interest rates tend to change with changes in the rate of inflation, substantiating the Fisher equation.
Short-term rates are more responsive to changes in inflation than long-term rates.
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Negative Interest Rates
Negative interest rates in Japan
Negative interest rates on US Treasury securities
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Forecasting Interest Rates
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