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.

Copyright© 2003 John Wiley and Sons, Inc. 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.

Copyright© 2003 John Wiley and Sons, Inc. Loanable Funds Theory

Copyright© 2003 John Wiley and Sons, Inc. 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 (fixed and inventory investments) Government budget deficit Foreign Borrowing

Copyright© 2003 John Wiley and Sons, Inc. 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↑

Copyright© 2003 John Wiley and Sons, Inc. 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↑

Copyright© 2003 John Wiley and Sons, Inc. 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↑

Copyright© 2003 John Wiley and Sons, Inc. Expected inflation and Interest Rates

Copyright© 2003 John Wiley and Sons, Inc. Interest Rate Changes and Changes in Inflation

Copyright© 2003 John Wiley and Sons, Inc. The Fisher Effect The Fisher equation is (1 + i) = (1 + r) (1 + π e ) where i = the nominal interest rate (in terms of money) r = the real interest rate (in terms of goods and services) π e = the expected inflation rate

Copyright© 2003 John Wiley and Sons, Inc. The Fisher Effect From the Fisher equation, with a little algebra, we see that the nominal interest rate is i = r + π e + (r * π e ) The lender gets compensated for: rent on money = r. compensation for loss of purchasing power on the principal = π e. compensation for loss of purchasing power on the interest = r * π e.

Copyright© 2003 John Wiley and Sons, Inc. Fisher Effect Example: 1-year $1,000 loan at 3% real interest rate and a 5% expected inflation rate. Items to PayCalculationAmount Principal $1, Rent on Money $1,000 * 3% Purchasing Power $1,000 * 5% Loss on Principal Purchasing Power $1,000 * 3% * 5% 1.50 Loss on Interest Total Compensation $1,081.50

Copyright© 2003 John Wiley and Sons, Inc. The Fisher Effect When expected inflation is low, (r * π e ) 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 + π e

Copyright© 2003 John Wiley and Sons, Inc. 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, π e, may less than actual inflation rates, π, yielding low or even negative actual real interest rates.

Copyright© 2003 John Wiley and Sons, Inc. 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.