1 / 16

CHAPTER 4

CHAPTER 4. INTEREST RATES. What are Interest Rates?. Cost of borrowing or the return on lending. Price of money. The time value of money. Opportunity cost of current consumption. As with any price, interest rates serve to allocate funds among alternative uses.

forbes
Download Presentation

CHAPTER 4

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. CHAPTER 4 INTEREST RATES

  2. What are Interest Rates? • Cost of borrowing or the return on lending. • Price of money. • The time value of money. • Opportunity cost of current consumption. • As with any price, interest rates serve to allocate funds among alternative uses.

  3. What Determine Interest Rates? • Loanable Funds Theory • Interest rates are determined in the debt markets by the supply of loanable funds (lending) and demand for loanable funds (borrowing). • The quantity supplied is positively related to interest rates, and the quantity demanded is negatively related to interest rates. • Increase in the supply of loanable funds (shift to the right) causes interest rates to decline. • Increase in the demand for loanable funds (shift to the right) causes interest rates to rise.

  4. Loanable Funds Theory

  5. Supply and Demand Sources • Households, business firms, government, and foreigners are both suppliers and demanders of loanable funds. During most periods, households are net suppliers of funds, whereas the government is almost always a net demander of funds. • Supply of Loanable Funds (SSU) • Consumer savings • Business savings (depreciation and retained earnings) • Government budget surplus (if any) • Foreign Savings • Demand for Loanable Funds (DSU) • Consumer purchases • Business investment • Government budget deficit • Foreign Borrowing

  6. Change in the Supply of Loanable Funds (Lending) • Preference for Consumption overtime: Preference for Future Consumption↑ → Savings↑ → S↑ (Shifts Right) → i↓ • Business Cycle Expansion↑ → Income↑ → Income↑ → Savings↑ → S↑ (Shifts Right) → i↓ • Expected Inflation → S↓ (Shifts Left) → i ↑

  7. Change in the Demand for Loanable Funds (Borrowing) • Government Budget Deficit↑ → Government Borrowing↑ → D↑ (Shifts Right) → i↑ • Business Cycle Expansion↑ → Availability of Good Investments↑ → D↑ (Shifts Right) → i↑ • Expected Inflation↑ → D↑ (Shifts Right) → i↑

  8. Expected Inflation and Interest Rates • Expected inflation is embodied in nominal interest rates - The Fisher Effect. • When inflation is expected to increase, lenders want compensation for expected decrease in the purchasing power of their loans → S↓ (Shifts Left) → i ↑. • When inflation is expected to increase, borrowers expect to pay less in terms of goods and services on their loans → D↑ (Shifts Right) → i↑.

  9. Expected inflation and Interest Rates

  10. Interest Rate Changes and Changes in Inflation

  11. The Fisher Effect • The Fisher equation is (1 + i) = (1 + r) (1 + πe) where i = the nominal interest rate (in terms of money) r = the real interest rate (in terms of goods and services) πe = the expected inflation rate

  12. The Fisher Effect • From the Fisher equation, with a little algebra, we see that the nominal interest rate is i = r + πe + (r * πe ) • The lender gets compensated for: • rent on money loaned r. • compensation for loss of purchasing power on the principal πe. • compensation for loss of purchasing power on the interest r * πe.

  13. Fisher Effect • Example: 1-year $1000 loan at 3% real interest rate and a 5% expected inflation rate. • Items to pay Calculation Amount • 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

  14. The Fisher Effect • When expected inflation is low, (r * πe) is approximately equal to zero, so it is dropped in many applications. The resulting equation is referred to as the approximate Fisher equation: i ≈ r + πe

  15. The Fisher Effect • The actual real interest rate reflect the impact of inflation. • r ≈ i - π, where the actual real interest rate, r, equals the nominal interest rate minus the actual inflation rate. • With increasing inflation rates, inflation premiums, πe, may less than actual inflation rates, π, yielding low or even negative actual real interest rates.

  16. Summary • Real interest rate compensates for delayed consumption. The higher the desire for current consumption, the higher the real interest rate. • The real interest rate is the long-term base of nominal interest rate. It is determined by real factors in the economy such as preferences for consumption over time, economic growth and government budget deficit. • The nominal interest rate is determined by the real interest rate and expected inflation as shown by the Fisher equation.

More Related