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CHAPTER 4
THE LEVEL OF INTEREST RATES
CHAPTER OVERVIEW AND LEARNING OBJECTIVES

This chapter defines the concept of an interest rate and examines the forces that establish the
level of interest rates in the economy.

The chapter distinguishes between the concepts of the real interest rate and a nominal interest
rate, with particular attention to the effect of inflation.

The chapter surveys Loanable Funds Theory and its implications for forecasting interest rates.
CAREER PLANNING NOTE: YOUR GOALS AND THE ECONOMY
The state of the economy and various industries when you graduate will affect the number and variety of
entry-level jobs available. Keep up with these conditions—read the The Wall Street Journal, Business
Week, and other business periodicals regularly. It’s not too early to study career choices, make contacts,
and plan your major course work. Seek out an internship related to your general career choice. Internships
are used more and more by employers to screen entry-level candidates. Be flexible. Study alternate paths
to your lifetime goals. Each choice you make is a step toward or a step away from them.
READING THE WALL STREET JOURNAL --THE WANT ADS
The classified ads in the Journal, titled "The Mart," give you a look beyond entry level. Almost all the
opportunities are for experienced managers, and the qualifications are fairly detailed. If you notice
“MBA/CFA preferred” or “large bank credit training a plus” again and again, that could be a hint. What
should you have on your resume 10 years from now, when you might be answering one of those ads?
TOPIC OUTLINE AND KEY TERMS
I.
What are interest rates?
A.
Rental price for money.
1.
Rent—price of borrowing another’s property.
2.
Interest rate—price of borrowing another’s purchasing power.
a.
Usually expressed as percentage of amount lent.
b.
Percentage usually stated in annual terms (“APR”).
B.
Penalty and reward: time value of consumption.
1.
Penalty to borrower for consuming before earning.
2.
Reward to lender for postponing current consumption.
C.
Like other prices, interest rates serve an allocational function in the economy.
1.
SSUs try to invest in financial claims at best possible return
2.
DSUs to try to finance projects at lowest possible cost.
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II.
III.
The Real Rate of Interest: Producers, Savers, and Real Output
A.
Producers seek financing for productive real assets.
1.
Expected return on projects “caps” interest rate producers can pay.
2.
As interest rate rises, projects are less profitable net of financing costs.
3.
As interest rate falls, projects become more attractive.
B.
Savers require compensation for postponing current consumption.
1.
Positive time preference for consumption—
All else equal, most people would rather consume earlier than later.
2.
As interest rate rises, more consumption is postponed in order to save.
3.
As interest rate falls, saving becomes less attractive.
C.
Producers and savers interact to determine an equilibrium rate of interest.
1.
Producers represent the “demand” for savings to finance real investment.
2.
Savers represent the “supply” of savings from deferred consumption.
3.
The real rate represents the “equilibrium”—
a.
The fundamental long-run interest rate in the economy.
b.
Called the “real” rate of interest because it is determined by the real
output of the economy.
c.
Estimated to be on average about 3 percent; varies between 2 and 4
percent with changes in economic conditions.
d.
A component of any “nominal” or “transactional” rate.
Loanable Funds Theory: Interest rate levels in a monetary economy with a financial sector.
A.
Supply of loanable funds—all sources of funds invested in financial claims:
1.
2.
3.
4.
B.
Demand for loanable funds—all uses of funds raised by issuing financial claims:
1.
2.
3.
C.
Consumer savings.
Business savings (depreciation, amortization, and retained earnings).
Government budget surpluses.
Central bank action.
Consumer credit purchases.
Business investment.
Government budget deficits.
Equilibrium interest rate—supply and demand meet (Exhibit 4.3).
1.
If competitive forces operate in the financial sector, laws of supply and demand
will bring rates into equilibrium.
2.
Equilibrium is temporary or dynamic. Any force that shifts supply or demand
will tend to change the equilibrium rate.
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IV.
Price expectations and interest rates.
A.
B.
Changes in purchasing power can cause unintended wealth transfers.
1.
Inflation rewards borrowers and punishes lenders.
a.
Borrowers receive more purchasing power than they repay.
b.
Lenders put more purchasing power at risk than they receive back.
2.
Deflation punishes borrowers and rewards lenders.
a.
Borrowers repay more purchasing power than they received.
b.
Lenders put less purchasing power at risk than they receive back.
3.
Rational borrowers and lenders try bid price expectations into interest rates; thus
any nominal interest rate should comprise at least 2 components:
a.
Rent on the money—“real” rate rewarding postponement of consumption.
b.
Adjustment for anticipated changes in purchasing power.
The Fisher Effect: Expected inflation is embodied in nominal interest rates—
1.
Investors want compensation for expected decreases in purchasing power, and
require increased interest rates to encourage them to hold financial assets.
2.
The Fisher effect, named after Irving Fisher, may be ordinarily expressed as
i = r +  Pe
Where i is the observed or nominal rate,
r is the real rate, and
Pe is the expected or ex ante inflation rate.
C.
Actual or ex post rates generally differ from expected rates.
1.
The "realized" rate of return may be expressed as
r = i - ΔPa,
Where r is the realized rate,
i is the observed or nominal rate, and
Pa, is the actual inflation rate.
D.
2.
As inflation increases, inflation premiums, Pe, may lag actual rates of inflation,
Pa, . Thus a positive nominal rate may represent a negative actual return.
3.
There is no evidence that, as a group, borrowers or lenders are able to “outpredict”
each other consistently.
Interest rate movements and inflation
1.
Historically, interest rates tend to change with changes in the rate of inflation,
substantiating the Fisher equation.
2.
Short-term rates are more responsive to changes in inflation than long-term
rates.
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V.
Forecasting interest rates: 2 methods.
A.
Economic Models
1.
Assume the pattern of causality among economic variables is stable into the future.
2.
Predict interest rates by estimating statistical relationships between output of
goods and services and interest rates.
B.
Flow of Funds Framework
1.
Relies on the Flow of Funds Accounts tracked by the Fed.
2.
Applies loanable funds theory to each financial market.
3.
Looks for “pressure points”—strength of demand or supply in particular markets.
COMPLETION QUESTIONS
1.
Like other prices, interest rates serve an __________ function in the economy.
2.
______ spending units supply loanable funds; ______ spending units demand loanable funds.
3.
_____ are usually net suppliers of loanable funds; _____ are usually a net demander of them.
4.
Inflation transfers wealth from ______ to _______.
5.
A nominal rate includes the __________ rate plus a premium for __________ inflation.
6.
Economic models are utilized to _________ future interest rate levels.
7.
Interest is a reward to _______ for ________ consumption.
8.
Nominal rate less actual inflation rate equals the __________ rate.
9.
An upward shift in the demand for loanable funds __________ interest rates.
10.
______ -term rates are more responsive to changes in inflation than ______ -term rates.
TRUE-FALSE QUESTIONS
T
F
1.
Increasing price levels increase the purchasing power of money.
T
F
2.
The rental price of money varies inversely with expected inflation.
T
F
3.
The real rate of interest is directly related to expected returns on capital projects.
T
F
4.
A positive nominal rate can represent a negative actual return.
T
F
5.
Neither borrowers nor lenders predict inflation especially well.
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T
F
6.
Forecasting interest rates is an important aspect of managing interest rate risk.
T
F
7.
Forecasting interest rate levels with economic models assumes that historical
relationships between economic variables will continue in the future.
T
F
8.
An increase in desired investment shifts the desired saving supply curve upward
to higher real rates of interest.
T
F
9.
A shift to the left in the supply of loanable funds (SL) reflects increased levels of
loanable funds supplied at any interest rate.
T
F
10.
Nominal interest rates reflect anticipated inflation.
MULTIPLE-CHOICE QUESTIONS
1.
Any of the following would be part of defining the real rate of interest except
a.
time preference for current versus future consumption.
b.
actual return received on a financial instrument
c.
return on investment in real assets
d.
fundamental long-term rate in the economy
2.
The real interest rate level would decrease if
a.
real capital investment opportunities increase.
b.
the productivity of capital goods decreases.
c.
the level of saving decreases.
d.
corporate tax rates are decreased.
3.
An expansion in the money supply by the Federal Reserve
a.
would shift the supply of loanable funds to the right and lower interest rates.
b.
would shift the supply of loanable funds to the left and increase interest rates.
c.
would shift the supply of loanable funds to the right and increase interest rates.
d.
would shift the supply of loanable funds to the left and lower interest rates.
4.
What compensation would a lender require for lending the U.S. Treasury $1000 for 1 year if the
real rate of interest is 3%, actual inflation last year was 5%, and expected inflation for the coming
year is 7%?
a. $1000
b. $30
c. $80
d. $100
5.
Which of the following interest rate forecasting methods utilizes a data based constructed by the
Federal Reserve System?
a.
the flow of funds approach
b.
naive forecasting models
c.
economic models
d.
efficient market modeling
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6.
An interest rate forecasting method utilizing past statistical relationships between economic output
and interest rates is called
a.
the flow of funds approach.
b.
naive forecasting models.
c.
economic models.
d.
efficient market modeling.
7.
The Fisher effect is a theory which states that
a.
nominal rates include the real rate of interest plus past annual inflation rates.
b.
nominal rates include the real rate of interest plus expected annual inflation rates.
c.
real rates are always positive.
d.
inflation has no impact upon interest rates.
8.
The demand for loanable funds may shift upward (increase) from
a.
a decline in the supply of loanable funds.
b.
a decline in business prospects.
c.
an improvement in technology.
d.
an expectation of an upcoming recession.
9.
The realized rate of return may be negative if:
a.
SSUs expected rate of inflation (Pe) were less than actual inflation (Pa).
b.
SSUs expected rate of inflation (Pe) were greater than actual inflation (Pa).
c.
SSUs over-anticipated the level of inflation.
d.
SSUs expected more inflation than was realized.
10.
An increase (shift to right) in the supply of loanable funds (SL) may be related to all of the
following except:
a.
an increase in the money supply.
b.
an increase in household thriftiness.
c.
an increase in household income.
d.
an increase in personal income taxes.
SOLUTIONS TO COMPLETION QUESTIONS
1.
allocational
2.
surplus; deficit
3.
households; businesses or governments
4.
lenders; borrowers
5.
real; expected
6.
forecast
7.
savers; postponing
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8.
realized
9.
increases
10.
short; long
SOLUTIONS TO TRUE-FALSE QUESTIONS
1.
F
Inflation reduces the purchasing power of money.
2.
F
Interest rates—the rental price of money— vary directly with expected inflation.
3.
T
The real rate of interest paid on financial assets must match (opportunity cost) that earned
on real capital assets to bid the funds into the financial sector.
4.
T
The inflation rate can exceed the real rate.
5.
T
There is no evidence that, as a group, borrowers or lenders are able to “outpredict”
each other consistently.
6.
T
Anticipating future interest rates and taking appropriate action is one important aspect of
managing interest rate risk.
7.
T
Historical relationships are established by testing the economic model with historical data.
Forecasts then extrapolate historical experience into the future.
8.
F
An upward shift in demand increases real rates of return. In turn, saving increases along
the supply line. Finally, the market is in equilibrium at a higher real rate and at an
increased quantity of savings.
9.
F
A shift to the left in supply reflects a decreased level for any interest rate.
10.
T
Nominal or market rates equal the real rate of interest plus the Fisher effect or an
increment for expected inflation, Pe.
SOLUTIONS TO MULTIPLE-CHOICE
1.
b
The other answers are more appropriate. The realized real rate would be the actual yield
less the actual rate of inflation.
2.
b
Expected return on capital projects “caps” the interest rate producers can pay.
3.
a
Added money supply shifts the supply of loanable to the right, lowering interest rates.
4.
d
The lender would charge the real rate plus expected inflation (Fisher effect) or 10 percent.
5.
a
The Flow of Funds Accounts are maintained by the Fed.
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6.
c
Economic models that accurately "model" past relationships between economic output
variables and interest rates are used to forecast future interest rates.
7.
b
Expected inflation is embodied in market rates.
8.
c
Improved technology increases the expected return on real capital (profit potential),
increasing desired investment.
9.
a
If inflation outpaces expected levels, investors will have underpriced their nominal rates in
the markets. Realized rates of return may be low or negative.
10.
d
Tax increases decrease the quantity of saving supplied at any interest rate.
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