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Chapter 7Chapter 7Interest Rates and Interest Rates and

Bond PricesBond Prices

© 2000 South-Western College Publishing

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Time Value ofTime Value of MoneyMoney

The terms on which one can trade off present purchasing power for future purchasing power; the interest rate

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CompoundingCompounding

A method used to determine the future value of a sum lent today

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PrincipalPrincipal is... is...

The original amount of funds lent

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Compounding the Future Value of Money Lent Today

Exhibit 7.1

Payment Today

$1,000

Future Value

$1,060

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DISCOUNTINGDISCOUNTING

A method used to determine the present value

of a sum to be received in the future

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PRESENT VALUEPRESENT VALUE

The value today of funds to be received or lent on a future date

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Value Today$1,000

Future Payment$1,060

Discounting: The Present Value of Money to Be Received in the Future

Exhibit 7.2

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PAR VALUEPAR VALUE

The face value printed on a bond; the amount the bond originally sold for

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COUPONCOUPON PAYMENTSPAYMENTS

The periodic payments made to bondholders, which are equal to the principal times the coupon rate

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DiscountDiscount From ParFrom Par

When a bond sells below its face value because interest rates have increased since the bond was originally issued

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YIELD TOYIELD TO MATURITYMATURITY

The return on a bond held to maturity, which includes both the interest return and any capital gain or loss

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Premium AbovePremium Above ParPar

When a bond sells above its face value because interest rates have decreased since the bond was originally issued

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The demand forThe demand for loanable loanable funds...funds...

The demand for borrowed funds by household, business, government or foreign DSUs

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$500

E1

Interest Rate

(percent)

Loanable Funds (in billions)

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Supply

The Supply of and Demand for Funds

Exhibit 7.3

Demand

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Supply ofSupply of Loanable FundsLoanable Funds

The supply of borrowed funds originating from (1) household, business, government, or foreign SSUs, or (2) the Fed in its provision of reserves in the conduct of monetary policy

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E1

Interest Rate

(percent)

Loanable Funds (in billions)

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SS

A Shift in the Demand for Funds

Exhibit 7.4

DDDD

E28

$500 $600

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Interest Rate

(percent)

Loanable Funds (in billions)

4

SSA Shift in the Supply for Funds

Exhibit 7.5

DD

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$500 $550

S SE1

E2

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Nominal Interest RateNominal Interest Rate

The market interest rate, or the real return plus the rate of inflation expected to prevail over the life of the asset

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Real InterestReal Interest RateRate

The interest rate corrected for changes in the purchasing power of money; the nominal interest rate minus the expected rate of inflation

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MONEY ILLUSIONMONEY ILLUSION

When spending units react to nominal changes caused by changes in prices, although real variables such as interest rates have not changed

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INFLATIONINFLATION PREMIUMPREMIUM

The amount of nominal interest added to the real interest rate to compensate the lender for the expected loss in purchasing power that will accompany any inflation

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Recessions Inflation Rate (percent)6 -month Commercial Paper Rate (percent)

Inflation and Interest RatesP

erce

nt

1960 ’65 ’70 ’75 ’80 ’85 ’90 ’95 20000

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10

15

Figure 7.6

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Interest Rate

(percent)

Loanable Funds (in billions)

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SS

Inflation and Interest Rates: A Graphical Treatment

Exhibit 7.7

DD

10

$500

S S

E1

E2

D D

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DividendsDividends

Profits distributed to stockholders

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A consolA consol is... is...

A perpetual bond with no maturity date; the issuer is never obliged to repay the principal but makes coupon payments each year forever