Capital Markets Chapter 24

Nominal and Real Interest Rates Nominal return represents how much money you will receive after 1 year for giving up 1 dollar of money today Real return represents how many goods you can buy if you give up the opportunity to buy 1 good today. Nominal interest rate is money interest rate. Real interest rate is goods interest rate.

Real Interest Rate The real interest rate on the loan is defined as the future goods received relative to current goods foregone

Measuring the Real Interest Rate Long-term 1.Use the yield on inflation protected securities. Short-term 1.Use nominal interest minus consensus inflation forecast 2.Use nominal interest rate minus your own inflation forecast

TIPS Bond The US Treasury offers bonds whose principal and coupon payments increase with the inflation rate. Investors are paid off in terms of real purchasing power. Yield is equivalent to a real interest rate. Additional Information from U.S. Treasury

Real & Nominal Interest Rates π 10 Year Forecast

Loanable Funds Market

Consider the financial market at its broadest and most abstract. an amalgamation of the bond market and the lending market (banks, etc.) Map the relationship between the interest rate and the quantity of funds that are lent. Supply curve represents the behavior of savers & lenders Demand curve represents the behavior of borrowers

Supply Curve: Loanable Funds Why does the supply curve slope up? When real interest rates offered by banks are high, savers are rewarded with more future consumption and are likely to be induced to save more. Caveat: If some savers are setting a target for their level of wealth at retirement, a higher interest rate reduces the amount they need to save. For this reason, many economists believe saving curve is very inelastic.

Demand Curve: Loanable Funds Why does the demand curve slope down? Firms borrow to finance investment projects. If the return on investment falls below the interest rate, the project is not worthwhile. The higher the interest rate, the fewer projects fall below the hurdle. Households borrow to finance housing. The higher are interest rates, the smaller is the house that the householders can buy with a mortgage payment that they can afford.

Globalization and the Loanable Funds Market Even ten years ago, we might have thought of the loanable funds market as being national in nature – especially for large economies. These days it appears that even the USA is part of a single global market. [China possible exception] Only very large changes in large countries or international trends will have an impact on real interest rates.

Competitive Market Equilibrium: Loanable Funds Market (Geometry) S LF D LF LF r* LF* r

Ex. Investment Boom in Emerging Markets McKinsey Report McKinsey Report S LF D LF LF r* LF* r r** D LF ' LF** 1 2

Ex. US Consumers become thriftier D LF LF r* LF* r LF** S LF ' r** 1 2 S LF

Savings We divide savings into 2 parts: S Private Private Saving (Household + Business Saving) +S Public Public Saving/Government Saving (Budget Surplus) = SNational Saving Public Savings is part of the supply of loanable funds if positive and part of demand for loanable funds if negative (as usual).

Government Surplus Government surplus is gap between govt revenue and spending and can be positive or negative. If net positive, it adds to the supply of loanable funds. If net negative, it adds to the demand for loanable funds.

Example: Government strikes a deal to raise taxes and cut spending LF r* LF* r r** LF** 1 2 D LF S LF S LF '

Ex.Japanese Government runs a deficit Budget Plan Budget Plan LF r* LF* r r** LF** 1 2 D LF D LF ' S LF

National Economy How do national economies relate to the global financial market? 1.Countries will face an external interest rate, r W, unaffected by national savings or investment. 2.International capital flows will make up the gap between savings and investment.

Competitive Market Equilibrium: Loanable Funds Market LF r* LF* r KA D LF S LF

Investment Boom [r Doesnt Rise, Gap made up by Capital Inflows] LF rWrW LF* r LF** 1 2 KA D LF D LF ' S LF

Consumers become less thrifty (r does not fall, gap made up by capital inflows) LF rWrW r 1 2 KA D LF S LF S LF '

Savings Glut Theory put forth by Fed Chairman explaining the U.S. trade deficit: Washington Post ArticleWashington Post Article

World Interest Rate Falls (Global Economy) LF rWrW r 1 2 rW'rW' 2 D LF S LF

Net Capital Outflows = Goods & Income Outflows Private Savings: Y + NFI -Tax – C Public Savings: Tax – G National Savings: S = Y+ NFI – C – G Capital Outflows: -KA = S – I S-I = NFI + (Y – C – G – I) = NFI +NX

US Current Account

Ex Ante Rate and the Fisher Effect Savings and investment decisions must be made before future inflation is known so they must be made on the basis of an ex ante (predicted) real interest rate. Fisher Hypothesis: Ex ante real interest rate is determined by forces in the financial market. Money interest rate is just the real ex ante rate plus the markets consensus forecast of inflation.

Great Inflation of the 1970s Source: St. Louis Federal Reserve Great Inflation DownloadDownload

Fisher Effect: OECD Economies Great Inflation of 1970s

Loanable Funds Market Fisher Effect LF r* LF* i* D LF S LF

We can also examine the ex post real return on a loan as the money interest rate less the actual outcome for inflation. The gap between actual and forecast inflation determines the gap between the ex post (actual) and ex ante (forecast) return. Ex Ante vs. Ex post

Unexpected Inflation Winners and Losers Higher than expected inflation means ex post real rates are lower than ex ante. Borrowers are winners/lenders are losers. Lower than expected inflation means ex post real rates are higher than ex ante. Lenders are winners/borrowers are losers.

Inflation Risk When inflation is variable, lenders will demand some premium for inflation risk. This will put cost on borrowers. High inflation rates tend to be associated with unpredictable inflation.

Learning Outcome Calculate the relationship between inflation, expected inflation, interest rates and real interest rates. Use the Loanable Funds model to analyze the effects of external events on savings, investment, and real interest rates in capital markets.