the level of interest rates chapter 4
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CHAPTER 4THE LEVEL OF INTEREST RATESCopyright 2006 John Wiley & Sons, Inc.
2What are Interest Rates?Rental price for money.Penalty to borrowers for consuming before earning.Reward to savers for postponing consumption.Expressed in terms of annual rates.As with any price, interest rates serve to allocate resources.Copyright 2006 John Wiley & Sons, Inc.
3The Real Rate of InterestIs the rate of interest determined by the returns earned on investments on productive assets.Real rate occurs at equilibrium between desired return on investment and time preference for consumption.Return on investments: Producers seek financing for real assets. The expected Return on Investments(ROI) is upper limit on interest rate producers can pay for financing the same investmentsTime preference for consumption: People prefer to consume goods today rather than tomorrow. This is called positive time preference for consumption. Savers require compensation for deferring consumption. Time value of consumption is lower limit on interest rate at which savers will provide financing.
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Copyright 2006 John Wiley & Sons, Inc.
4Determinants of the Real Rate of Interest
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5Equilibrium ConditionThe equilibrium rate of interest is the point where the desired level of borrowing by DSU equals the desired level of lending by SSUs.
The equilibrium rate of interest is also called as the real rate of interest and determined by the real output factors in the economy.
Copyright 2006 John Wiley & Sons, Inc.
6Fluctuations in the real rate : Demand factors :
New technology spawns an increase in investment opportunities and also increases the desired level of borrowing.Reduction in corporate taxes increases the amount on investment by firms increases the borrowing and cause the real rate of interest to increase.Other demand factors:Increase in the productivity of existing capitalIncrease in expected business product demandDemographic changesThe equilibrium rate of interest is also called as the real rate of interest and determined by the real output factors in the economy.
Copyright 2006 John Wiley & Sons, Inc.
7Fluctuations in the real rate : Supply factors :
A supply factor that would shift the desired level of lending by decreasing the real rate of interests would be A decrease in the tax rate of the individuals. Other factors:Monetary policy actionsShift in consumer attitudes about savingsChanges in economic conditions
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Copyright 2006 John Wiley & Sons, Inc.
8Loanable Funds TheorySupply of loanable fundsAll sources of funds available to invest in financial claims
Demand for loanable fundsAll uses of funds raised from issuing financial claims
Equilibrium interest rateCopyright 2006 John Wiley & Sons, Inc.
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Supply of loanable funds
All sources of funds available to invest in financial claims:Consumer savingsBusiness savingsGovernment budget surplusesCentral Bank Action
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10Demand for Loanable FundsAll uses of funds raised from issuing financial claims:Consumer credit purchasesBusiness investmentGovernment budget deficits
Copyright 2006 John Wiley & Sons, Inc.
11Equilibrium Interest RateIf competitive forces operate in financial sector, laws of supply and demand will bring rates into equilibrium.
Equilibrium is temporary or dynamic: Any force that shifts supply or demand will tend to change interest rates.Copyright 2006 John Wiley & Sons, Inc.
12Loanable Funds Theory
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13Loanable Funds Theory
Copyright 2006 John Wiley & Sons, Inc.
14Loanable Funds Theory
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15Loanable Funds Theory
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16Price Expectations and Interest RatesUnanticipated inflation benefits borrowers at expense of lenders.
Lenders charge added interest to offset anticipated decreases in purchasing power.
Expected inflation is embodied in nominal interest rates: The Fisher Effect.Copyright 2006 John Wiley & Sons, Inc.
17Fisher EffectThe exact Fisher equation is:
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18Fisher Effect, cont.From the Fisher equation, we derive the nominal (contract) rate:
We see that a lender gets compensated for:rental of purchasing poweranticipated loss of purchasing power on the principalanticipated loss of purchasing power on the interest
Copyright 2006 John Wiley & Sons, Inc.
19Fisher Effect: Example1-year $1000 loan Parties agree on 3% rental rate for money and 5% expected rate of inflation.
Items to payCalculationAmountPrincipal $1,000.00Rent on money$1,000 x 3% 30.00PP loss on principal$1,000 x 5% 50.00PP loss on interest$1,000 x 3% x 5% 1.50Total Compensation $1,081.50Copyright 2006 John Wiley & Sons, Inc.
20Simplified Fisher EquationThe third term in the Fisher equation is negligible, so it is commonly dropped. The resulting equation is
Copyright 2006 John Wiley & Sons, Inc.
21Expectations ex ante v. Experience ex post
Realized rates of return reflect impact of inflation on past investments.
r = i - Pa, where the "realized" rate of return from past transactions, r, equals the nominal rate minus the actual annual rate of inflation.
As inflation increases, expected inflation premiums, Pe, may lag actual rates of inflation, Pa, yielding low or even negative actual returns.Copyright 2006 John Wiley & Sons, Inc.
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23Impact of Inflation under Loanable Funds Theory
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Copyright 2006 John Wiley & Sons, Inc.
25Interest Rate Movements and InflationHistorically, interest rates tend to change with changes in the rate of inflation, substantiating the Fisher equation.
Short-term rates are more responsive to changes in inflation than long-term rates.