hbc620 lecture3 levelof interest rate srd(1)

Lecture 3: Chapter 4

THE LEVEL OF INTEREST RATES

Presented By

Dr Sarod Khandaker

1Presented by Dr Sarod Khandaker

WHAT ARE Interest Rates

1. The interest rate is the ‘rental price’ of money expressed as an annual percentage of the amount borrowed.

2. For the borrower, interest is the penalty paid for consuming income before it is earned.

3. For the lender, interest is the reward for postponing current consumption.

4. Always in annual percentage term.

Presented by Dr Sarod Khandaker 2

THE REAL RATE OF INTEREST The fundamental determinant of interest rates

is the interaction of investment (and investors) and saving (and savers).

Most of the people prefer consume goods today rather than tomorrow (positive time preference)

The equilibrium interest rate is also called the real rate of interest. This is the fundamental long run interest rate of an economy.


Investment

The higher the return on investment, the more likely producers are to undertake a particular investment project.

At higher interest rates, fewer business projects can earn the rate of return required by investors.

The lower the interest rate is, the higher the demand for capital will be (and vice versa).


Saving Most people prefer to consume goods today

rather than tomorrow.

At low rates of interest, most people will postpone very little consumption for saving (and vice versa).

Therefore, the supply of saving will be higher, the higher the interest rate.



Country Current Rate Previous Rate Change Last Change

Australia 3.50% 3.75% -0.25% June 06 2012

Brazil 9.00% 9.75% -0.75% Apr 18 2012

Canada 1.00% 0.75% 0.25% Sep 08 2010

Chile 5.00% 5.25% -0.25% Jan 13 2012

China 6.00% 6.31% -0.31% Jul 05 2012

Colombia 5.00% 5.25% -0.25% Jul 30 2012

Czech Republic 0.75% 1.00% -0.25% May 06 2010

Denmark 1.25% 0.75% 0.50% Jul 08 2011

Egypt 9.25% 8.25% 1.00% Nov 24 2011

European Monetary Union 0.75% 1.00% -0.25% Jul 05 2012

Hong Kong SAR 0.50% 1.50% -1.00% Dec 17 2008

Hungary 7.00% 6.50% 0.50% Dec 20 2011

Iceland 5.75% 5.50% 0.25% Jun 13 2012

India 8.00% 8.50% -0.50% Apr 17 2012

Indonesia 5.75% 6.00% -0.25% Feb 09 2012

Israel 2.25% 2.50% -0.25% Jul 01 2012

Japan 0.10% 0.30% -0.20% Dec 19 2008

Korea, Republic of 3.25% 3.00% 0.25% Jun 10 2011

Malaysia 3.00% 2.75% 0.25% Jul 08 2010

Mexico 4.50% 4.75% -0.25% Jul 17 2009

New Zealand 2.50% 3.00% -0.50% Mar 09 2011

Norway 1.50% 1.75% -0.25% Mar 14 2012

Philippines 3.75% 4.00% -0.25% Jul 26 2012

Poland 4.75% 4.50% 0.25% May 09 2012

South Africa 5.50% 6.00% -0.50% Sep 10 2010

Sweden 1.50% 1.75% -0.25% Feb 16 2012

Switzerland 0.00% 0.25% -0.25% Aug 03 2011

Taiwan 1.88% 1.75% 0.13% Jul 01 2011

Thailand 3.00% 3.25% -0.25% Jan 25 2012

Turkey 5.75% 6.25% -0.50% Aug 05 2011

United Kingdom 0.50% 1.00% -0.50% Mar 05 2009

United States 0.25% 1.00% -0.75% Dec 16 2008

Interest Rate Around the Globe

The Interaction of Saving and Investment

Figure 4.1 Determinants of the real interest rate


Loanable Funds Theory

A theory that may be used to explain shorter term movements in interest rates is loanable funds theory.

According to this theory, interest rates are determined by the demand for, and supply of, loanable funds.

SSUs supply loanable funds and DSUs demand loanable funds.


Loanable Funds: THEORY OF INTEREST

Figure 4.2 Sources of supply of and demand for loanable funds


Loanable Funds: Geometry

Figure 4.3 Interest rate determination in a loanable funds framework


Price Expectations and Interest Rates

Changes in the price level affect the realised return of lenders so change their lending behaviour.

Changes in the price level also affects the cost that borrowers must pay for these loans.

Loan contracts must incorporate the impact of expected changes in the price level to avoid unwarranted transfers of purchasing power between borrowers and lenders.


The Fisher Equation

The nominal interest rate is divided into two partsThe real rate of interest that exists in the absence of price changes.

An expectations component that captures the expected percentage change in the price level over the life of the contract.

This can be expressed as the Fisher equation.

Where i is the nominal interest rate, r is the real rate of interest, and ΔPe is the expected annual percentage change in the average price level in the

economy.


ePri

A RESTATEMENT OF

THE FISHER EQUATION

Note the following:

I. The equation uses the expected percentage price level changes NOT the observed inflation rate.

II. The expected change in the price level may be positive, negative or constant.

III. The nominal interest rate is the rate of interest actually observed in the financial markets.


Realised Rate of Return

aPir

• The Fisher equation implies the possibility that the actual (real) rate of return on a loan contract will differ from the nominal rate that was agreed to.

• Formally, the real rate of return is expressed as:


Realised Rate of Return If actual inflation is higher at the end of the

loan than expected inflation at the beginning, the lender will have a lower realised rate of return (and vice versa).

This means that there has been an unintended transfer of purchasing power to the borrower.


Australian Realised Rates of Return, 1979 - 2008

Figure 4.4


FORECASTING INTEREST RATES

Economic Models

Economic modelling is one approach to interest rate forecasting.

Economic models predict interest rates by estimating the statistical relationship between economic variables and the level of interest rates.

The key assumption is that the causality among variables is stable.



Flow-of-funds account forecasting

Flow of funds data show the movement of saving through the system.

Analysts examine ‘pressure points’ at which the demand for funds exceeds the supply of funds (or vice versa).

Such imbalances indicate the possibility of interest rate changes.



The RBA Model

Inflation targeting framework used by other nation, e.g. England, NZ.

The RBA relies on single-equation models rather than larger-scale macroeconomic models (RBNZ).

In each equation, which deal with various economic components, the parameters can be adjusted to examine the impact of changes on the various components (including feedback effects).



How good are forecasters?

a. Forecasting is not immune from error.

b. Studies have shown that forecasters are not consistently accurate.

c. Over longer periods of time, errors can be considerable.


Islamic Banking

Islamic banking systems rely on the principles of the Qur’an.

The Qur’an forbids the use of interest and investment in financial instruments that involve interest.

This differs markedly from Western banking systems that are based the

concept of interest.


What is ‘USURY”


1. The practice of lending money and charging the borrower interest, especially at an exorbitant or illegally high rate.

2. An excessive or illegally high rate of interest charged on borrowed money.

3. Archaic Interest charged or paid on a loan.

The Prohibition of Usury

The prohibition of lending at interest (usury) stems from one key premise.

That is, a transaction that ensures a guaranteed return to one party regardless of the circumstances of the other is unfair.

The unfairness exists because both parties do not risk loss.


PRINCIPLES OF ISLAMIC BANKING

Islamic Banking is based on the principles of trade, partnership, sharing of gains and losses, and prohibition of reckless risk. It prohibits:

Interest-based banking Gharar –unclear contracts Maysir–speculation Financing of haram transactions -– alcohol,

gambling, pork, etc.


TYPES OF LENDING CONTRACTS

• Murabaha – sale contract• Mudaraba – Part financing• Musharika – Partnership• Ijara – rental/lease• Tawarruq – overdraft facilities.


Providing Finance in an Islamic System

Islamic banks provide finance through profit/loss sharing and partnerships.

Investors receive a fixed share of profits when they occur.

Despite the long history of Islam, Islamic banking is quite new (dating from the 1950s).

Recent growth has attracted Western bankers such as Citibank, which operates Citi Islamic Investment Bank.


Summary


hbc620 lecture3 levelof interest rate srd(1)

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