unit 2 interest rate ppt

7/28/2019 UNIT 2 Interest Rate Ppt

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Determinants of interest

rate


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Interest rate Interest rate is the price demanded by the lender from the borrower for

the use of borrowed money.

In other words, interest is a fee paid by the borrower to the lender onborrowed cash as a compensation for forgoing the opportunity of earning

income from other investments that could have been made with the

loaned cash.

Thus, from the lenders perspective, interest can be thought of as an

"opportunity cost or "rent of money" and interest rate as the rate at

which interest (oropportunitycost) accumulates over a period of time.

The longer the period for which money is borrowed, the larger is the

interest (or the opportunity cost).

The amount lent is called the principal.

Interest rate is typically expressed as percentage of the principal and in

annualized terms.

From aborrowers perspective, interest rate is the cost of capital. In other

words, it is the cost that a borrower has to incur to have access to funds.


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NOMINAL INTEREST RATE VS REAL INTEREST RATE

Nominal interest rates refer to the rate of interest prior to taking inflation into

account. Depending on its application, an inflation and risk premium must be added

to the real interest rate in order to obtain the nominal rate.

The Real interest rate is corrected for inflation and is calculated as the nominal interest

rate minus the rate of inflation. In the case of a loan, it is this real interest that the lender

receives as income. If the lender is receiving 8 percent from a loan and inflation is 8

percent, then the real rate of interest is zero because nominal interest and inflation are

equal. A lender would have no net benefit from such a loan because inflation fully

diminishes the value of the loan's profit.

Nominal versus real interest rate

The relationship between real and nominal interest rates can be described in the equation:real interest rate = nominal interest rate - expected inflation

In this analysis, the nominal rate is the stated rate, and the real interest rate is the interest

after the expected losses due to inflation. Since the future inflation rate can only be

estimated, so the real interest rates may be different; the premium paid to actual inflation

may be higher or lower. In contrast, the nominal interest rate is known in advance.


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FACTORS AFFECTING LEVEL OF INTEREST RATES

Interest rates are typically determined by the supply of and demand

for money in the economy. If at any given interest rate, the demand

for funds is higher than supply of funds, interest rates tend to rise andvice versa. Theoretically speaking, this continues to happen as interest

rates move freely until equilibrium is reached in terms of a match

between demand for and supply of funds. In practice, however,

interest rates do not move freely. The monetary authorities in the

country (that is the central bank of the country) tend to influence

interest rates by increasing or reducing the liquidity in the system.

Broadly the following factors affect the interest rates in an economy:

1. Monetary Policy

2. Growth in the economy

3. Inflation

4. Global liquidity

5. Uncertainty


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Monetary Policy- The central bank of a country controls

money supply in the economy through its monetary policy. InIndia, the RBIs monetary policy primarily aims at price stability

and economic growth. If the RBI loosens the monetary policy

(i.e., expands money supply or liquidity in the economy),

interest rates tend to get reduced and economic growth getsstimulated; at the same time, it leads to higher inflation. On the

other hand, if the RBI tightens the monetary policy, interest rates

rise leading to lower economic growth; but at the same time,

inflation gets curbed. So, the RBI often has to do a balancing act.The key policy rate the RBI uses to inject (or reduce) liquidity

from the monetary system is the repo rates (or reverse repo

rates). Changes in repo rates influence other interest rates in the

economy too.


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Growth in the economyIf the economic growth of an

economy picks up momentum, then the demand for

money tends to go up, putting upward pressure on interest

rates.

InflationInflation is a rise in the general price level of

goods and services in an economy over a period of time.When the price level rises, each unit of currency can buy

fewer goods and services than before, implying a

reduction in the purchasing power of the currency. So,

people with surplus funds demand higher interest rates, asthey want to protect the returns of their investment

against the adverse impact of higher inflation. As a result,

with rising inflation, interest rates tend to rise. The

opposite happens when inflation declines.


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Global liquidity

If global liquidity is high, then there is astrong chance that the domesticliquidity of any country will

also be high, which would put a downward pressure on interest

rates.

Uncertainty

If the future of economic growth isunpredictable, the lenders tend to cut down on their lending or

demand higher interest rates from individuals or companies

borrowing from them as compensation for the higher default

risks that arise at the time of uncertainties or do both. Thus,

interest rates generally tend to rise at times of uncertainty. Of

course, if the borrower is the Government of India, then the

lenders have little to worry, as the government of a country

can hardly default on its loan taken in domestic currency.


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Impact of interest rates

There are individuals, companies, banks and even governments, who have to borrow

funds for various investment and consumption purposes. At the same time, there are

entities that have surplus funds. They use their surplus funds to purchase bonds or

Money Market instruments. Alternatively, they can deposit their surplus funds with

borrowers in the form of fixed deposits/ wholesale deposits.

Changes in the rate of interest can have significant impact on the way individuals or

other entities behave as investors and savers. These changes in investment and savingbehavior subsequently impact the economic activity in a country.

For example, if interest rates rise, some individuals may stop taking home loans, while

others may take smaller loans than what they would have taken otherwise, because of

the rising cost of servicing the loan. This will negatively impact home prices as demand

for homes will come down. Also, if interest rates rise, a company planning an expansionwill have to pay higher amounts on the borrowed funds than otherwise. Thus the

profitability of the company would be affected. So, when interest rates rise, companies

tend to borrow less and invest less. As the demand for investment and consumption in

the economy declines with rising interest, the economic growth slows down. On the

other hand, a decline in interest rates encourage investment spending and consumption

spending activities and the economy tends to grow faster.


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LEVEL OF INTEREST RATES

Interest is the price the borrowers must pay to lenders to obtain the use of money

for a period of time. As all the other prices are determined in different markets, theequilibrium rate of interest is also determined in financial markets. Given below are

three theories about the determination of interest rates:

The Classical Theory: This Theory states that the rate of interest is determined by real

factors, namely the supply of savings and the demand for investment, the productivity

of capital goods providing the elements of demand and the peoples time preference

limiting the supply.

The Loanable Fund Theory: This theory states that the supply of savings plus the

credit creation by the financial system on the one hand, and total borrowing in the

economy on the other, determine the rate of interest.

The keynesian Theory: This theory states that the rate of interest is a reward for

parting with liquidity, and it is determined by the demand for and supply of money in

the economy.


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Theory of term structure of interest rates

Interest rates are also related to the term to maturity of a security. This

relationship is often called as the term structure of interest rates or yield curve.

The term structure of interest rates compares the interest rates on securitiesassuming that all characteristics (i.e., default risk, liquidity risk) except maturities

are same.

Securities with identical default risk, liquidity, and tax characteristics may still

have different interest rates because the time remaining to maturity is different. Yield curve is a plot of the yield on securities with differing terms to maturity

but the same risk, liquidity and tax considerations.

Shape of the yield curve:

1. Usually upward-sloping

(long-term i > short-term i )

sometimes inverted

(long-term i < short-term i )

2. Flat implies short- and long-term rates are similar.


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Theory of term structure of

interest rates

There are three theories that economists use to

explain the term structure of interest rates:

1) Expectations Hypothesis

2) Segmented Markets Theory

3) The Liquidity Premium (preferred habitat)

Theory.


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The Expectation TheoryExpectations theory, also termed expectations hypothesis, is one of

the most common economic theories of term structure. It comes in

several variations, the most widely known being the unbiased

expectations theory and it is based on the following assumptions:

There is perfect competition in the financial markets.

The investors are rational, i.e., they wish to maximise the yield of

their holding period.

Investors have perfect foresight, and a large enough body of

investors hold uniform expectations about the future level and

changes of short term interest rates & security prices.

There are no transaction costs.

Securities of different maturities are perfect substitutes for each

other, i.e., they are homogeneous.


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With the help of these assumptions, it is posited that todays

long term rate is the geometric mean of the current short-term

rates and the successive forward or expected one-period short-

term rates during the long term period .

It means slope of yield curve tells us direction of expected

future ST rates

So


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if expect ST rates to RISE,

then average of ST rates will be >

current ST rate It means LT rates > ST rates

so yield curveSLOPES UP


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ST rates expected to rise

maturity

yield


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if expect ST rates to FALL,

then average of ST rates will be ST yields

or yield curve slopes up.


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if ST rates are expected to rise

Then liquidity premium is small

maturity

yield yield curve

small liquidity premium


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if ST rates are expected to stay the same

Then liquidity premium is larger,

maturity

yield yield curve

large liquidity premium


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if ST rates are expected to fall

then liquidity premium is vary large

maturity

yield yield curve

Vary large liquidity premium


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Drawbacks It is doubtful whether the investor are really more

averse to capital risk than income risk.

How do we interpret yield curve?

slope due to 2 things:

(1) exp. about future ST rates

(2) size of liquidity premium

Difficult to quantify liquidity premium

By assuming risk (liquidity) premium will be mostly

positive, the theory implies that the price or interest

rates will be mostly increasing. This is questionable.

Determinants of general structure of interest rates


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Determinants of general structure of interest rates

Default risk: Risk that a security issuer will default on the security by missing

an interest or principal payment. All financial assets, except governments

securities are subject to some degree of default risk although they differ in their

degree of risk.

Tax status: tax features cause difference on similar financial assets or claims.

Marketability or liquidity: The financial assets differ in their marketability or

liquidity that is they differ in respect of the possibility that a significant amount

of security can be sold relatively quickly without price concessions.

Inflation: The continual increase in the price level of a basket of goods and

services.

Special Provisions: Provisions (e.g., convertibility and callability) that impact

the security holder beneficially or adversely and as such are reflected in the

interest rate on security that contains such provisions.


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Monetary policy

Monetary policy is the process by which

monetary authority of a country, generally a

central bank controls the supply of money in

the economy by exercising its control overinterest rates in order to maintain price

stability and achieve high economic growth. In

India, the central monetary authority is theReserve Bank of India (RBI).

I t t t h i f dit t l / t li
http://en.wikipedia.org/wiki/Monetary_policyhttp://en.wikipedia.org/wiki/Monetary_policyhttp://en.wikipedia.org/wiki/Reserve_Bank_of_Indiahttp://en.wikipedia.org/wiki/Reserve_Bank_of_Indiahttp://en.wikipedia.org/wiki/Monetary_policyhttp://en.wikipedia.org/wiki/Monetary_policy


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Open Market Operations

The open market operation refers to the purchase and/or sale of short term and

long term securities by the RBI in the open market. This is very effective and

popular instrument of the monetary policy. The OMO is used to wipe out

shortage of money in the money market, to influence the term and structure of

the interest rate and to stabilize the market for government securities, etc. It is

important to understand the working of the OMO. If the RBI sells securities in

an open market, commercial banks and private individuals buy it. This reduces

the existing money supply as money gets transferred from commercial banks to

the RBI. Contrary to this when the RBI buys the securities from commercial

banks in the open market, commercial banks sell it and get back the money they

had invested in them. Obviously the stock of money in the economy increases.

This way when the RBI enters in the OMO transactions, the actual stock of

money gets changed. Normally during the inflation period in order to reduce the

purchasing power, the RBI sells securities and during the recession or

depression phase it buys securities and makes more money available in the

economy through the banking system. Thus under OMO there is continuous

buying and selling of securities taking place leading to changes in the

availability of credit in an economy.

Instruments or technique of credit control / monetary policy


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Cash Reserve Ratio

Cash Reserve Ratio is a certain percentage ofbank

deposits which banks are required to keep with RBI

in the form of reserves or balances .Higher the CRRwith the RBI lower will be the liquidity in the system

and vice-versa.RBI is empowered to vary CRR

between 15 percent and 3 percent. But as per the

suggestion by the Narshimam committee Report theCRR was reduced from 15% in the 1990 to 5 percent

in 2002. Current CRR is 4.75% percent.
http://en.wikipedia.org/wiki/Bank_depositshttp://en.wikipedia.org/wiki/Bank_depositshttp://en.wikipedia.org/wiki/Liquidityhttp://en.wikipedia.org/wiki/Liquidityhttp://en.wikipedia.org/wiki/Bank_depositshttp://en.wikipedia.org/wiki/Bank_deposits


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Statutory Liquidity RatioEvery financial institute have to maintain a

certain amount of liquid assets from their time

and demand liabilities with the RBI. Theseliquid assets can be cash, precious metals,

approved securities like bonds etc. The ratio of

the liquid assets to time and demand liabilities

is termed as StatutoryLiquidity Ratio. There

was a reduction from 38.5% to 25% because of

the suggestion by Narshimam Committee. The

current SLR is 24%.
http://en.wikipedia.org/wiki/Statutoryhttp://en.wikipedia.org/wiki/Liquidityhttp://en.wikipedia.org/wiki/Liquidityhttp://en.wikipedia.org/wiki/Statutory


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Bank Rate Policy

Bank rate is the rate of interest charged by the RBI for

providing funds or loans to the banking system. This banking

system involves commercial and co-operative banks, Industrial

Development Bank of India, IFC, EXIM Bank, and other

approved financial institutes. Funds are provided eitherthrough lending directly or rediscounting of bill of exchange.

Increase in Bank Rate increases the cost of borrowing by

commercial banks which results into the reduction in credit

volume to the banks and hence declines the supply of money.Increase in the bank rate is the symbol of tightening of RBI

monetary policy. Bank rate is also known as Discount rate.

The current Bank rate is 9%.


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Repo Rate and Reverse Repo Rate

Repo rate is the rate at which RBI lends to commercial banks

generally against government securities. Reduction in Repo

rate helps the commercial banks to get money at a cheaper rate

and increase in Repo rate discourages the commercial banks to

get money as the rate increases and becomes expensive.

Reverse Repo rate is the rate at which RBI borrows moneyfrom the commercial banks. The increase in the Repo rate will

increase the cost of borrowing and lending of the banks which

will discourage the public to borrow money and will

encourage them to deposit. As the rates are high theavailability of credit and demand decreases resulting to

decrease in inflation. This increase in Repo Rate and Reverse

Repo Rate is a symbol of tightening of the policy. The current

repo rate is 8% and reverse repo rate is 7%.


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Fixing Margin Requirements

The margin refers to the "proportion of the loanamount which is not financed by the bank". Or in

other words, it is that part of a loan which a borrower

has to raise in order to get finance for his purpose. A

change in a margin implies a change in the loan size.This method is used to encourage credit supply for

the needy sector and discourage it for other non-

necessary sectors. This can be done by increasing

margin for the non-necessary sectors and by reducingit for other needy sectors. Example:- If the RBI feels

that more credit supply should be allocated to

agriculture sector, then it will reduce the margin and

even 85-90 percent loan can be given.


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Moral Suasion

It implies to pressure exerted by the RBI on theindian banking system without any strict action for

compliance of the rules. It is a suggestion to banks. It

helps in restraining credit during inflationary periods.

Commercial banks are informed about the

expectations of the central bank through a monetary

policy. Under moral suasion central banks can issue

directives, guidelines and suggestions for commercialbanks regarding reducing credit supply for

speculative purposes.


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Types Of Monetary policy

1. EXPANSIONERY MONETARY POLICY

2.

TIGHT MONETERY POLICY

EXPANSIONERY MONETARY POLICY


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EXPANSIONERY MONETARY POLICY

Problem: Recession and unemployment

Measures: (1) Central bank buys securities through open market

operation

(2) It reduces cash reserves ratio

(3) It lowers the bank rate

Money supply increases

Investment increases

Aggregate demand increases

Aggregate output increases with

increase in investment


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TIGHT MONETERY POLICY

Problem: Inflation

Measures: (1) Central bank sells securities through open market

operation

(2) It raises cash reserve ratio and statutory liquidity

(3) It raises bank rate

(4) It raises maximum margin against holding of stocks of goods

Money supply decreases

Interest rate raises

Investment expenditure declines

Aggregate demand declines

Price level falls

M f l


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Measures of money supply

The total supply of money in circulation in a given country'seconomy at a given time. There are several measures for the

money supply, such as M1, M2, and M3.

The money supply is considered an important instrument forcontrolling inflation by those economist who say that growthin money supply will only lead to inflation if money demand is

stable In order to control the money supply, regulators have to decide

which particular measure of the money supply to target .

The broader the targeted measure, the more difficult it will beto control that particular target. However, targeting anunsuitable narrow money supply measure may lead to asituation where the total money supply in the country is notadequately controlled.


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Reserve Money (M0): Currency in circulation + Bankers deposits with

the RBI + Other deposits with the RBI

M1: Currency with the public + Deposit money of the public (Demand

deposits with the banking system + Other deposits with the RBI).

M2: M1 + Savings deposits with Post office savings banks.

M3: M1+ Time deposits with the banking system = Net bank credit to

the Government + Bank credit to the commercial sector + Net foreign

exchange assets of the banking sector + Governments currencyliabilities to the publicNet non-monetary liabilities of the banking

sector (Other than Time Deposits).

M4: M3 + All deposits with post office savings banks (excluding

Th D d f M


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The Demand for Money

The demand for money is affected by several factors, including the level of

income, interest rates, and inflation as well as uncertainty about the future.

The way in which these factors affect money demand is usually explainedin terms of the three motives for demanding money: the transactions, the

precautionary, and the speculative motives

Transactions motive. The transactions motive for demanding money arises

from the fact that most transactions involve an exchange of money.Because it is necessary to have money available for transactions, money

will be demanded. The total number of transactions made in an economy

tends to increase over time as income rises. Hence, as income or GDP rises,

the transactions demand for money also rises.

Precautionary motive. People often demand money as aprecaution against

an uncertain future. Unexpected expenses, such as medical or car repair

bills, often require immediate payment. The need to have money available

in such situations is referred to as the precautionary motive for

demanding money.


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Speculative motive:

Money, like other stores of value, is an asset. The demand for an asset depends on both

its rate of return and its opportunity cost. Typically, money holdings provide no rateof return and often depreciate in value due to inflation. The opportunity cost of holding

money is the interest rate that can be earned by lending or investing one's money

holdings. The speculative motive for demanding money arises in situations where

holding money is perceived to be less risky than the alternative of lending the money or

investing it in some other asset.

For example, if a stock market crash seemed imminent, the speculative motive for

demanding money would come into play; those expecting the market to crash would

sell their stocks and hold the proceeds as money. The presence of a speculative motive

for demanding money is also affected by expectations of future interest rates and

inflation. If interest rates are expected to rise, the opportunity cost of holding money

will become greater, which in turn diminishes the speculative motive for demanding

money. Similarly, expectations of higher inflation signify a greater depreciation in the

purchasing power of money and therefore lessen the speculative motive for demanding

money.


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Money supply

Money is something that is used as a medium of exchange, a store of value

and a unit of account.

In its narrow most definition (M0) money comprises of all currency in

circulation.

M1 is all currency plus demand deposits.

Adding post office deposits to M1 we get M2.

M3 consists of currency plus demand deposits plus time deposits.

Adding post office deposits to M3 we get M4.

The Supply and Demand of Money


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People hold money:

To conduct transactions

For precautionary reasons, such as to meet emergencies, such as unexpectedmedical bills

As a store of value

Holding money has an opportunity cost in the sense that the money could be

invested elsewhere and earn interest. Even if the money is held in an interest-earning checking account, a higher rate of interest could be earned by purchasing

financial instruments such as bonds.

As the rate of interest goes higher, the opportunity cost of money increases. So

as interest rates go up (down), people will be less (more) willing to hold money.

The supply of money is usually determined by the Central Bank and the targeted

supply of money is not directly related to the interest rate.

A graph for the supply and demand for money, as a function of the interest rate,

would appear similar to figure 1 on the next slide..


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Figure 1 The Supply and Demand for Money

Note that this demand curve assumes other relevant factors are held constant. If thequantity of goods produced increases and/or the price level increases, the demand

for money will increase. This causes the demand curve to shift to the right. If

economic activity declines and/or prices go down, then demand for money will

decrease.

Changes in the availability of financial instruments are also changing the demand for

money over time. The widespread availability of credit cards has reduced the

amount of money that households need to keep on hand.


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INTEREST RATE IN INDIA- AN

INTERNATIONAL COMPARISION

The short term rate of interest in India has ususally been higher than the

similar rate in other countries, especially W Germany & Japan. There does

not exist a clear increasing or decreasing trend in the differential between

the Indian and world short term rates.

The long term rate of interest in India was mostly lower than the similar

rate in other countries till 1985. Thereafter, the long term rate in India hasbeen mostly higher than other countries.

Thus, while both the short-term and long-term interest rates abroad have

somewhat hardened in India since 1990.

Both the short-term and long-term interst rates abroad have fluctuated more

than those rates in India. The flexibility and variability of all interest rates

in other countries have been far greater than in India.The short-term rate of

interest has been more volatile than the long-term rate in all the countries

including India.


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THANK YOU

unit 2 interest rate ppt

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