THE LEVEL OF INTEREST RATES CHAPTER 4 THE LEVEL OF INTEREST RATES

What are Interest Rates? Rental price for money. Penalty to borrowers for consuming before earning. Reward to savers for postponing consumption. Expressed in terms of annual rates. As with any price, interest rates serve as allocative function ,as they allocate funds between the DSU and the SSU. SSU wants to buy the financial claims with the highest returns ,whereas DSUs want to sell financial claims at the lowest possible interest rates. Copyright© 2006 John Wiley & Sons, Inc.

The Real Rate of Interest What determines the interest rates? 1. Production opportunities :Producers seek financing to invest in capital projects. 2. Individual’s time preference for consumption: Most people like to consume goods today rather than tomorrow. This is called positive time preference for consumption. Savers require compensation for deferring consumption. Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. Expected Return on Investment is upper limit on interest rate producers can pay for financing. Time value of consumption is lower limit on interest rate at which savers will provide financing. Real rate occurs at equilibrium between desired real investment and desired saving. Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. The determination of market interest rates occurs in demand and supply framework. The supply side is saving curve. At low rates, most people postpone very little consumption for the sake of saving(i.e. they save less) and at high rates, consumers tend to save more. Hence, the supply is upward sloped. Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. The demand is the Investment curve. At high rates, fewer businesses can earn an expected return high enough to cover this high interest costs. Therefore, they borrow less. On the other hand, at low rates, they tend to borrow more. Hence, the demand is downward sloped. The equilibrium rate of interest is called the real rate of interest(r*). Copyright© 2006 John Wiley & Sons, Inc.

Determinants of the Real Rate of Interest Copyright© 2006 John Wiley & Sons, Inc.

Shifts in the demand and the supply Factors that shift the investment curve to the right Factors that shift the saving curve to the right Advance in Technology Consumer attitudes towards savings, if they become more thriftier(prefer to save). Increase in the productivity of existing capital Reduction in the income taxes Increase in the business product demand Increase in the personal income Reduction in the corporate taxes Reduction in the expected risk of investment projects Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. Loanable Funds Theory In the short run, the interest rate depends on the supply and demand of loanable funds, because its difficult to view them in investment and saving framework. Supply of loanable funds—SSU supply loanable funds to the markets by purchasing the financial claims. Demand for loanable funds—DSU demand loanable funds by issuing the financial claims. Equilibrium interest rate(r0) Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. All the three economic units are both supplier and demanders of the loanable funds Sources of Supply for Loanable Funds Sources of Demand for Loanable Funds Consumer Savings Consumer credit purchases Business Savings Business investment Government Budget surplus Government Budget deficits Central Bank actions. Copyright© 2006 John Wiley & Sons, Inc.

Equilibrium Interest Rate If competitive forces operate in financial sector, laws of supply and demand will bring rates into equilibrium. Equilibrium is temporary or dynamic: Any force that shifts supply or demand will tend to change interest rates. Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. The supply function is upward sloped because as interest rate rises, the quantity supplied of lonable funds increases. Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. The demand function is downward sloped because the higher the interest rates the lower the quantity demanded of loanable funds. Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. Loanable Funds Theory Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. Loanable Funds Theory Copyright© 2006 John Wiley & Sons, Inc.

Shifts in the demand and supply of loanable funds Factors that shifts the supply of loanable funds to the right Factors that shifts the demand of loanable funds to the right 1. Increase in consumer savings. 1.Increase in Business investment. 2.Increase in business savings. 2.Increase in consumer credit purchases. 3.Increase in Government budget surplus. 3.Increase in Government deficits. 4. Central bank increase the money supply. Copyright© 2006 John Wiley & Sons, Inc.

Price Expectations and Interest Rates Unanticipated inflation during the life of a loan contract benefits borrowers at expense of lenders, because the borrower pay the lender money with less purchasing power. Lenders charge added interest to offset anticipated decreases in purchasing power. Expected inflation is present in nominal interest rates: The Fisher Effect. Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. Fisher Effect The exact Fisher equation is: Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. Fisher Effect, cont. From the Fisher equation, we derive the Original Fisher equation nominal (contract) rate: We see that a lender gets compensated for: rental of purchasing power anticipated loss of purchasing power on the principal anticipated loss of purchasing power on the interest Copyright© 2006 John Wiley & Sons, Inc.

Fisher Effect: Example 1-year $1000 loan Parties agree on 3% rental rate for money and 5% expected rate of inflation. 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 Copyright© 2006 John Wiley & Sons, Inc.

Simplified Fisher Equation The third term in the Fisher equation is negligible, so it is commonly dropped. The resulting equation is Note 1 : the nominal interest rate includes: (1) the real interest rate and (2) the anticipated change in price level over the life of the contract.` Note 2: if Δpe equals ZERO, nominal interest rate (i) = real interest rate (r ). Copyright© 2006 John Wiley & Sons, Inc.

Dr. Hisham Abdelbaki - FIN 221 - Ch. 4 The Realized Real Rate The Fisher equation is based on expected inflation rate. The actual rate of inflation may be different from the anticipated rate. This may lead to the realized rate of return on a loan to be different from the nominal interest rate agreed on at the time of the loan contract. The realized (actual) real rate is calculated as : r = i - ΔPa, Where; r = is the realized real rate of return, i = the nominal interest rate, and ΔPa = is the actual rate of inflation. Dr. Hisham Abdelbaki - FIN 221 - Ch. 4

Copyright© 2006 John Wiley & Sons, Inc. If the actual inflation turns to be higher than the expected inflation, then there was unintended transfer of purchasing power to the borrower from the lender (borrower gain and lender lose). If the actual inflation turns to be lower than the expected inflation, then there was unintended transfer of purchasing power to the lender from the borrower (borrower lose and lender gain). Copyright© 2006 John Wiley & Sons, Inc.

Interest Rate Movements and Inflation Historically, interest rates tend to change with changes in the rate of inflation, substantiating the Fisher equation. Short-term rates are more responsive to changes in inflation than long-term rates. Copyright© 2006 John Wiley & Sons, Inc.