chapter 4 interest rates. copyright© 2003 john wiley and sons, inc. what are interest rates? cost...

CHAPTER 4

INTEREST RATES

Copyright© 2003 John Wiley and Sons, Inc.

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.


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.


Loanable Funds Theory


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 savingsBusiness savings (depreciation and retained earnings)Government budget surplus (if any)Foreign Savings

Demand for Loanable Funds (DSU)Consumer purchasesBusiness investment (fixed and inventory investments)Government budget deficitForeign Borrowing


Change in the Supply of Funds (Lending)

Preference for Consumption overtime:

Preference for Future Consumption↑ (People become more Patient) → Savings↑ → S↑ (Shifts Right) → i↓

Business Cycle Expansion↑ → Income↑ → Savings↑ → S↑ (Shifts Right) → i↓

Expected Inflation → S↓ (Shifts Left) → i↑


Change in the Demand for Funds (Borrowing)

Preference for Consumption overtime: Preference for Future Consumption↑ (People

become more Patient) → Borrowing↓ → D↓ (Shifts Left) → i↓ Business Cycle Expansion↑ → Availability of Good Investments↑ → D↑ (Shifts Right) → i↑Government Budget Deficit↑ → Government Borrowing↑ → D↑ (Shifts Right) → i↑Expected Inflation↑ → D↑ (Shifts Right) → i↑


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 decline 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↑


Expected inflation and Interest Rates


Interest Rate Changes and Changes in Inflation


The Fisher EffectThe 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


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 = r.

compensation for loss of purchasing power on the principal = πe.

compensation for loss of purchasing power on the interest = r * πe.


Fisher EffectExample: 1-year $1,000 loan at 3% real interest rate and a 5% expected inflation rate.

Items to Pay Calculation AmountPrincipal $1,000.00Rent on Money $1,000 * 3% 30.00Purchasing Power $1,000 * 5% 50.00

Loss on PrincipalPurchasing Power $1,000 * 3% * 5% 1.50

Loss on InterestTotal Compensation $1,081.50


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


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.


SummaryReal 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.

chapter 4 interest rates. copyright© 2003 john wiley and sons, inc. what are interest rates? cost...

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