Download 6.02 Understand economic indicators to recognize economic trends

6.00 Understand economics trends and
communication.
6.02 Understand economic indicators to
recognize economic trends and conditions.
6.02-D Explain the economic impact of
interest-rate fluctuations.
5-176 5-177 Define 6.02-D
• Interest rate:
– The interest rate is the yearly price charged by a lender to a
borrower in order for the borrower to obtain a loan. This is
usually expressed as a percentage of the total amount loaned
called annual percentage rate (APR).
Nominal interest rate:
– one where the effects of inflation have not been accounted
Changes in the nominal interest rate often move with changes in
the inflation rate, as lenders not only have to be compensated
for delaying their consumption, they also must be compensated
for the fact that a dollar will not buy as much a year from now
as it does today.
• Real interest rate:
– is one where the effects of inflation have been factored.
For Example: Nominal vs. Real
• Suppose we buy a 1 year bond for face value that pays 6%
at the end of the year. We pay $100 at the beginning of the
year and get $106 at the end of the year. Thus the bond
pays an interest rate of 6%. This 6% is the nominal interest
rate, as we have not accounted for inflation. Whenever
people speak of the interest rate they're talking about the
nominal interest rate, unless they state otherwise.
• Now suppose the inflation rate is 3% for that year. We can
buy a basket of goods today and it will cost $100, or we can
buy that basket next year and it will cost $103. If we buy
the bond with a 6% nominal interest rate for $100, sell it
after a year and get $106, buy a basket of goods for $103,
we will have $3 left over.
5-176 5-177 Define 6.02-D
 Interest-rate fluctuation: Is a change in the
interest rate.
 Liquidity risk: The uncertainty associated
with the ability to sell an asset on short
notice without loss of value.
 Default risk : The uncertainty associated
with the payment of financial obligations
when they come due. Put simply, the risk of
non-payment.
5-176 5-177 Define 6.02-D
 Maturity risk, price risk:
The greater the maturity of an investment, the greater the
change in price for a given change in interest rates. The
uncertainty associated with potential changes in the price of an
asset caused by changes in interest rate levels and rates of return
in the economy. This risk occurs because changes in interest
rates affect changes in discount rates which, in turn, affect the
present value of future cash flows. The relationship is an inverse
relationship. If interest rates (and discount rates) rise, prices fall.
The reverse is also true. Since interest rates directly affect
discount rates and present values of future cash flows represent
underlying economic value, we have the following relationships.
5-176 5-177 6.02-D
• Discuss causes of interest-rate fluctuations.
• The Fed rate is the most important factor that affects
interest rates. If short-term interest rates are lowered or
increased, then the costs of inter-borrowing between banks
changes accordingly. This is reflected in the interest rates
charged by banks from their customers.
• However, various other economic factors also have an
impact on interest rates. Short-term interest rates are the
first to get affected by these factors, while long-term
interest rates, like those charged on a mortgage, catch up
with the changes slowly and they are determined by the
long term outlook of the economy. That is why there is
always more certainty about the returns from your
investments if you invest for a longer time frame.
5-176 5-177 6.02-D
• Explain the impact of interest rate fluctuations
on an economy.
– The impact of falling interest rates is that it is less
costly to get credit. However, the returns on your
savings would also be lower. Similarly, if interest
rate increases, then loans become costlier, but you
earn more on your savings.
5-176 5-177 6.02-D
• Describe the relationship between interest rates and the
demand for money.
• Money is a narrowly defined term which includes things
like paper currency, traveler's checks, and savings accounts.
It doesn't include things like stocks and bonds, or forms of
wealth like homes, paintings, and cars. Since money is only
one of many forms of wealth, it has plenty of substitutes.
The interaction between money and its substitutes explain
why the demand for money changes.
• A reduction in the interest rate will increase the Demand
for Money and a rise in the interest rate causes the
demand for money to fall.
5-176 5-177 6.02-D
 Describe the relationship between inflation
and interest rates.
 There is typically an inverse relationship, high
interest rates equals low inflation, low interest
rates = high inflation.
5-176 5-177 6.02-D
Discuss factors that create differences in the amount of interest
charged on credit transactions (e.g., levels and kinds of risk,
borrowers’ and lenders’ rights, and tax considerations).
 To mitigate the impact of default risk, lenders often
charge rates of return that correspond the debtor's level
of default risk. The higher the risk, the higher the required
return, and vice versa.
 Standard measurement tools to gauge default risk include
FICO scores for consumer credit, and credit ratings for
corporate and government debt issues. Credit ratings for
debt issues are provided by Nationally Recognized
Statistical Rating Organizations (NRSROs), such as
Standard & Poor's, Moody's and Fitch Ratings.
5-176 5-177 6.02-D
• Describe kinds of risk associated with
variances in interest rates (i.e., default,
liquidity, and maturity).
– default risk, interest rate risk, price risk,
reinvestment rate risk, liquidity risk, inflation risk,
purchasing power risk, market risk, firm specific
risk, project risk, financial risk, business risk,
foreign exchange risk, translation risk, &
transaction risk.
5-176 5-177 6.02-D
• Explain how fiscal policies can affect interest rates.
– Fiscal policy has a clear effect upon output. But there is a secondary,
less readily apparent fiscal policy effect on the interest rate.
– Basically, expansionary fiscal policy pushes interest rates up, while
contractionary fiscal policy pulls interest rates down. The rationale
behind this relationship is fairly straightforward. When output
increases, the price level tends to increase as well. This relationship
between the real output and the price level is implicit. According to
the theory of money demand, as the price level rises, people demand
more money to purchase goods and services. Given that there is no
change in the money supply, this increased demand for money leads
to an increase in the interest rate. The opposite is the case with
contractionary fiscal policy. When output decreases, the price level
tends to fall as well. Again, this relationship between the real output
and the price level is implicit. According to the theory of money
demand, as the price level falls, people demand less money to
purchase goods and services. Given that there is no change in the
money supply, this decreased demand for money leads to a decrease
in the interest rate. This is how fiscal policy affects the interest rate.