1. CHAPTER 4 THE LEVEL OF INTEREST RATES

2. Copyright© 2003 John Wiley and Sons, Inc. What are Interest Rates? Rental price for money. The time value of consumption. Opportunity cost. Expressed in terms of annual rates. As with any price, interest rates serve to allocate funds to alternative uses.

3. Copyright© 2003 John Wiley and Sons, Inc. The Real Rate of Interest There is a preference for "real" applications for savings such as consumption or real investment. Real interest rate compensates for delayed consumption or giving up real investment opportunities. The higher the desire for consumption or real investment opportunities, the higher the real rate of interest.

4. Copyright© 2003 John Wiley and Sons, Inc. The Real Rate of Interest, cont. The real rate of interest is determined by the demand and supply for savings at a given point in time. The real rate is the price needed to delay consumption of funds demanded for real investment. Upward shifts to the right (increases) in demand for desired real investment cause the real rate of interest to increase. If the supply of desired savings shifts upward (increases) to the right, the real rate of interest declines.

5. Copyright© 2003 John Wiley and Sons, Inc. Determinants of the Real Rate of Interest

6. Copyright© 2003 John Wiley and Sons, Inc. Loanable Funds Theory of Interest The level of interest rates is determined by the supply and demand for loanable funds. The real rate of interest is the long-term base rate of interest. Short-run supply/demand factors and financial market risks affect nominal interest rates. The quantity demanded of loanable funds, DL, is inversely related to the level of interest rates; the quantity supplied is directly related to interest rates.

7. Copyright© 2003 John Wiley and Sons, Inc. Loanable Funds Theory of Interest, cont. DSUs demand loanable funds for home building, plant/equipment, and inventory financing. The supply of loanable funds available for financial investment may come from decreasing money balances or past savings.

8. Copyright© 2003 John Wiley and Sons, Inc. Supply/Demand Sources Notice that households, businesses, and governmental units are both suppliers and demanders of loanable funds. During most periods, households are net suppliers of funds, whereas the federal government is almost always a net demander of funds. Supply of Loanable Funds (SSU) Consumer savings Business savings (depreciation and retained earnings) State and local government budget surpluses Federal government budget surplus (if any) Federal Reserve increases the money supply (  M) Demand for Loanable Funds (DSU) Consumer credit purchases Business investment Federal government budget deficits State and local government budget deficits

9. Copyright© 2003 John Wiley and Sons, Inc. Loanable Funds Theory

10. Copyright© 2003 John Wiley and Sons, Inc. Loanable Funds Theory

11. Copyright© 2003 John Wiley and Sons, Inc. Loanable Funds Theory

12. Copyright© 2003 John Wiley and Sons, Inc. Loanable Funds Theory

13. Copyright© 2003 John Wiley and Sons, Inc. Price Expectations and Interest Rates Expected inflation, ex ante, is embodied in nominal interest rates -- The Fisher Effect. Investors want compensation for expected decreases in the purchasing power of their wealth. If investors feel the prices of real goods will increase (inflation), it will take increased interest rates to encourage them to place their funds in financial assets.

14. Copyright© 2003 John Wiley and Sons, Inc. Fisher Effect The formula for the Fisher equation is:

15. Copyright© 2003 John Wiley and Sons, Inc. Fisher Effect, cont. From the Fisher equation, with a little algebra, we see that the nominal (contract) rate is: From this equation we see that a lender gets compensated for: rent on money loaned, compensation for loss of purchasing power on the principal, compensation for loss of purchasing power on the interest.

16. Copyright© 2003 John Wiley and Sons, Inc. Fisher Effect, cont. Contract rate example for: 1-year $1000 loan when the loan parties agree on a 3% rental rate for money and a 5% expected rate of inflation. Items to payCalculationAmount Principal $1,000.00 Rent on money$1,000 x 3% $30.00 PP loss on principal$1,000 x 5% $50.00 PP loss on interest$1,000 x 3% x 5% $1.50 Total Compensation $1,081.50

17. Copyright© 2003 John Wiley and Sons, Inc. Fisher Effect (concluded) The third term in the Fisher equation is approximately equal to zero, so it is dropped in many applications. The resulting equation is referred to as the approximate Fisher equation and is the following:

18. Copyright© 2003 John Wiley and Sons, Inc. Price Expectations and Interest Rates Actual realized ex-post rates of return reflect the impact of inflation on past investments or on investors. r = i -  P a, where the annual "realized" rate of return from past securities purchases, r, equals the annual nominal rate minus the actual annual rate of inflation. With ever-increasing rates of inflation, investors' inflation premiums, P e, may lag actual rates of inflation, P a, yielding low or even negative actual real rates of return.

19. Copyright© 2003 John Wiley and Sons, Inc. Exhibit 4.4 Nominal/Realized Rates

20. Copyright© 2003 John Wiley and Sons, Inc. Interest Rate Changes and Changes in Inflation, Exhibit 4.5

21. Copyright© 2003 John Wiley and Sons, Inc. Interest Rate Changes and Changes in Inflation (concluded ) What do we learn from the previous slide? Interest rates change with changes in inflation. Short-term interest rates change more than long-term interest rates for a given change in inflation.