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Money, Credit, and Interest Rates: Understanding Determinants and Yield Curves

This chapter explores the relationship between money, credit, and interest rates, including the impact of supply and demand, the determination of yields on debt instruments, and the factors influencing the general level of interest rates. It also examines the various risks involved in real estate finance and their impact on interest rates. The yield curve is explained through the liquidity premium theory, market segmentation theory, and expectations theory.

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Money, Credit, and Interest Rates: Understanding Determinants and Yield Curves

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  1. Chapter 2 Money, Credit, and the Determination of Interest Rates

  2. 2-1 Chapter 2 Learning Objectives • Understand how the supply and demand for money and credit affect (and are affected by) the economy and the general level of interest rates • Understand how yields on individual debt instruments are determined • Understand why securities of different maturities may have different yields

  3. 2-2 Determining Interest Rates • LIQUIDITY EFFECT • Money supply goes up • Demand for bonds goes up • Interest rates go down • INCOME EFFECT • Income goes up • Demand for credit goes up • Interest rates go up

  4. 2-3 Yield Curves • LIQUIDITY PREMIUM • Premium paid for liquidity • SEGMENTED MARKETS • Market divided into distinct segments • EXPECTATIONS THEORY • Current rates are the average of expected future rates • The current two-year rate is the average of the current one-year rate and the one-year rate a year from now

  5. 2-4 The General Level of Interest Rates • Interest rate on an instrument reflects general market rates and the risk of the specific instrument • Equation of Exchange MV = PT • M = money supply • V = stable velocity of circulation • P = passive price level • T = stable volume of trade • Fisher Equation i = r + p

  6. 2-5 Risks In Real Estate Finance • DEFAULT RISK • Risk that the borrower will not repay the mortgage per the contract • CALLABILITY RISK • Borrower may repay the debt before maturity • MATURITY RISK • Other things held constant, the longer the maturity the greater the change in value for a given change in interest rates

  7. 2-6 Risks In Real Estate Finance • MARKETABILITY RISK • Risk that the asset doesn’t trade in a large, organized market • INFLATION RISK • Risk in loss of purchasing power • INTEREST RATE RISK • Risk of loss due to changes in market interest rates • Fixed-income assets are most susceptible

  8. The Yield Curve • Relates maturity and yield at the same point in time • Explaining the structure of the yield curve: • Liquidity Premium Theory • Market Segmentation Theory • Expectations Theory – the long-term rate for some period is the average of the short-term rates over that period

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