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Chapter
2
Money, Credit,
and the
Determination of
Interest Rates
Chapter 2
Learning Objectives
Understand how the supply and
demand for money and credit affect
(and are affected by) the economy and
the general level of interest rates
 Understand how yields on individual
debt instruments are determined
 Understand why securities of different
maturities may have different yields

The General Level of
Interest Rates
Interest rate on an instrument reflects
general market rates and the risk of the
specific instrument
 Equation of Exchange MV = PT

M = money supply
V = stable velocity of circulation
P = passive price level
T = stable volume of trade

Fisher Equation
i=r+p
Determining Interest
Rates

LIQUIDITY EFFECT
– Money supply goes up
– Demand for bonds goes up
– Interest rates go down

INCOME EFFECT
– Income goes up
– Demand for credit goes up
– Interest rates go up
Risks In Real Estate
Finance



DEFAULT RISK
– Risk that the borrower will not repay the
mortgage per the contract
CALLABILITY RISK
– Borrower may repay the debt before
maturity
MATURITY RISK
– Other things held constant, the longer the
maturity the greater the change in value
for a given change in interest rates
Risks In Real Estate
Finance



MARKETABILITY RISK
– Risk that the asset doesn’t trade in a large,
organized market
INFLATION RISK
– Risk in loss of purchasing power
INTEREST RATE RISK
– Risk of loss due to changes in market
interest rates
– Fixed-income assets are most susceptible
The Yield Curve


Relates maturity and yield at the same point
in time
Explaining the structure of the yield curve:
– Liquidity Premium Theory
– Market Segmentation Theory
– Expectations Theory – the long-term rate for some
period is the average of the short-term rates over
that period
Explaining the Yield Curve



LIQUIDITY PREMIUM
– Premium paid for liquidity
SEGMENTED MARKETS
– Market divided into distinct segments
EXPECTATIONS THEORY
– Current rates are the average of expected
future rates
– The current two-year rate is the average of
the current one-year rate and the one-year
rate a year from now