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CHAPTER 4
THE LEVEL OF INTEREST RATES
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.
Copyright© 2003 John Wiley and Sons, Inc.
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.
Copyright© 2003 John Wiley and Sons, Inc.
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.
Copyright© 2003 John Wiley and Sons, Inc.
Determinants of the
Real Rate of Interest
Copyright© 2003 John Wiley and Sons, Inc.
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.
Copyright© 2003 John Wiley and Sons, Inc.
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.
Copyright© 2003 John Wiley and Sons, Inc.
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
Copyright© 2003 John Wiley and Sons, Inc.
Loanable Funds Theory
Copyright© 2003 John Wiley and Sons, Inc.
Loanable Funds Theory
Copyright© 2003 John Wiley and Sons, Inc.
Loanable Funds Theory
Copyright© 2003 John Wiley and Sons, Inc.
Loanable Funds Theory
Copyright© 2003 John Wiley and Sons, Inc.
Price Expectations and
Interest 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.
Copyright© 2003 John Wiley and Sons, Inc.
Fisher Effect
The formula for the Fisher equation is:
1  i   1  r 1  Pe 
where
i  the observed nominal rate of interest,
r  the real rate of interest,
Pe  the expected annual rate of inflation.
Copyright© 2003 John Wiley and Sons, Inc.
Fisher Effect, cont.
From the Fisher equation, with a little
algebra, we see that the nominal (contract)
rate is:
i  r  Pe  r * Pe 
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.
Copyright© 2003 John Wiley and Sons, Inc.
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
Principal
Rent on money
PP loss on principal
PP loss on interest
Total Compensation
Calculation
Amount
$1,000.00
$1,000 x 3%
$30.00
$1,000 x 5%
$50.00
$1,000 x 3% x 5%
$1.50
$1,081.50
Copyright© 2003 John Wiley and Sons, Inc.
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:
i  r  Pe
Copyright© 2003 John Wiley and Sons, Inc.
Price Expectations and
Interest 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.
Copyright© 2003 John Wiley and Sons, Inc.
Exhibit 4.4 Nominal/Realized
Rates
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Interest Rate Changes and
Changes in Inflation, Exhibit 4.5
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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.
Copyright© 2003 John Wiley and Sons, Inc.