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Number of US Bank Failures 1 FDIC usually closes banks on Fridays. Why? Total No. of YearFailed banksGA portion

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2 Market Rate of Interest Rate Market rate of interest performs an allocative function by assuring (a)SSUs rate will be low enough so someone will borrow from them (b)DSUs rate will be high enough so someone will lend to them.

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3 Production Opportunities In addition to Fed, interest rates affected by business opportunities (production opportunities, in book) in the economy. The lower the rate of interest, the greater the number of business ventures that should be profitable.

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4 Sources of loanable funds consumer savings business savings local/state/federal government surpluses central bank action that increases money supply Uses for loanable funds consumer credit purchases business investment state/local/federal government deficits Loanable Funds

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5 Nominal vs. Real Rate of Interest Nominal interest rate is the observed rate (the market rate). Real rate of interest is nominal rate minus inflation. Prior to 6 years ago, real rate of interest had historically been between about 2% and 4%.

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Let i denote nominal rate of interest r denote real rate of interest (i.e., rental rate) denote expected rate of inflation. 6 Regular Fisher Equation Regular Fisher equation

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Exact Fisher Equation The three terms see to it that lender gets compensated for: 1. rental of purchasing power 2. anticipated loss of purchasing power on the principal 3. anticipated loss of purchasing power on the interest 7

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Example 1 We lend $100 for one year under the condition that the $100 gains 5% in purchasing power. Expected inflation is 8%. What interest rate should we charge? 8

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Example 2 Going to lend a company $3 billion to help it through a financial crisis at a rental rate of 10% plus compensation for 4% inflation. Boss says figure out interest rate to charge. What is difference between regular and exact? 910/8

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Realized Real Interest Rate ex ante means based upon anticipated effects (i.e., what lies ahead) ex post means based upon analysis of past performance (i.e., what lies behind) ex ante, we assume r and forecast (expected) ex post, we know both i and (actual) Note difference between and 10

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Other Forms of Fisher Equations regular for ex ante use: exact for ex ante use: regular for ex post use: exact for ex post use: 11

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Example 3 approx: exact: Suppose a loan were set up with a nominal interest rate of 12%. What would be realized real rate of return if inflation turned out to be 4%? 12

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When Inflation Deviates From Anticipated Inflation greater than anticipated: benefits borrowers, Results in an unintended transfer of PP from lender to borrower. Inflation less than anticipated: benefits lenders. Results in an unintended transfer of PP from borrower to lender. So what is Fisher Effect? …that embedded in nominal interest rates are inflation expectations. 13

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