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Copyright© 2006 John Wiley & Sons, Inc. 1

Power Point Slides for:

Financial Institutions, Markets, and Money, 9th Edition

Authors: Kidwell, Blackwell, Whidbee & Peterson

Prepared by: Babu G. Baradwaj, Towson University

And

Lanny R. Martindale, Texas A&M University

CHAPTER 4

THE LEVEL OF INTEREST RATES


What 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.


The Real Rate of Interest

Producers seek financing for real assets. Expected ROI is upper limit on interest rate producers can pay for financing.

Savers require compensation for deferring consumption. Time value of consumption is lower limit on interest rate at which savers will provide financing.

Real rate occurs at equilibrium between desired real investment and desired saving.


Determinants of the Real Rate of Interest


Loanable Funds Theory

Supply of loanable funds—All sources of funds available to invest in financial claims

Demand for loanable funds—All uses of funds raised from issuing financial

claims

Equilibrium interest rate


Supply of loanable funds—

All sources of funds available to invest in financial claims:

Consumer savings

Business savings

Government budget surpluses

Central Bank Action


Demand for Loanable Funds

All uses of funds raised from issuing financial claims:

Consumer credit purchases

Business investment

Government budget deficits


Equilibrium Interest Rate

If 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.










Price Expectations and Interest Rates

Unanticipated 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.


Fisher Effect

The exact Fisher equation is:

inflation. of rate annual expected the

interest, of rate real ther

interest, of rate nominal observed the i

where

111

e

e

P

Pri


Fisher 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

ee PrPri *


Fisher Effect: Example

1-year $1000 loan Parties agree on 3% rental rate for money and 5% expected rate of inflation.

Items to pay Calculation AmountPrincipal $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% 1.50

– Total Compensation $1,081.50


Simplified Fisher Equation

The third term in the Fisher equation is negligible, so it is commonly dropped. The resulting equation is

ePri


Expectations 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.



Impact of Inflation under Loanable Funds Theory



Interest Rate Movements and Inflation

Historically, 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.

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