Copyright © 2000 by Harcourt, Inc. All rights reserved Chapter 14 Interest Rates, Exchange Rates, and Inflation: Theories and Forecasting

Copyright © 2000 by Harcourt, Inc. All rights reserved Loanable Funds Theory Borrowers and lenders are categorized into five distinct types. Households –The only net suppliers of funds in any given period –Household savings = income minus consumption minus household borrowing Businesses The central bank –Has control over changes in the money supply Government Foreign investors

Copyright © 2000 by Harcourt, Inc. All rights reserved The Supply of Loanable Funds Choices for disposition of funds Spend money on consumable goods. Save money by investing in financial assets. Hold or hoard cash. Key motivation for savings is the expected rate of return. Because investors have a time preference for consumption, the expected rate of interest must always be positive in order to induce substantial postponement of consumption.

Copyright © 2000 by Harcourt, Inc. All rights reserved Holding or hoarding cash does not provide a positive rate of return. So why hold cash balances? Transactions demand Precautionary demand Speculative demand The level of transactions and precautionary demand is not tied to the expected rate of interest. Speculative demand is sensitive to expected interest rates.

Copyright © 2000 by Harcourt, Inc. All rights reserved Other Nonrate Factors Influencing Savings Households Income level Involuntary savings programs Voluntary savings for emergencies and retirements Businesses Potential real asset investments The nature of the business enterprise The philosophy of the firm’s managers and owners

Copyright © 2000 by Harcourt, Inc. All rights reserved Foreign sector The difference between interest rates in the U.S. and the expected rate available in other countries. The Money Supply (M)

Copyright © 2000 by Harcourt, Inc. All rights reserved Demand for Loanable Funds Business borrowing is sensitive to interest rates. Funds raised by firms will depend on the optimal capital budgets. The investment opportunity schedule and the resulting demand for loanable funds are inversely related to interest rates. Government demand for credit is relatively inelastic with respect to interest rates. Governments borrow whenever they face budget deficits or when they need to finance major construction projects.

Copyright © 2000 by Harcourt, Inc. All rights reserved Foreign sector demand for credit. Foreign business and foreign government borrowings are motivated by the same factors affecting their domestic counterparts. The difference between U.S. rates and rates abroad will determine the amount of actual borrowing in the U.S. markets.

Copyright © 2000 by Harcourt, Inc. All rights reserved Loanable Funds ($) Interest Rate (%) 0 (Household + Business +  M + Foreign) S LF Loanable Funds ($) SUPPLY OF LOANABLE FUNDS The supply of loanable funds increases as the expected interest rate increases. 0 (Business +Government + Foreign) D LF Interest Rate (%) DEMAND FOR LOANABLE FUNDS The demand for loanable funds decreases as the expected interest rate increases.

Copyright © 2000 by Harcourt, Inc. All rights reserved I* S LF D LF Q*Q* Loanable Funds ($) Interest Rate (%) 0 EQUILIBRIUM RATES OF INTEREST The equilibrium level of interest rates is the rate at which the quantity of loanable funds demanded equals the quantity of loanable funds supplied.

Copyright © 2000 by Harcourt, Inc. All rights reserved Changes in the Supply and Demand The political, economic, or behavioral factors that shift either curve are expected to result in changes in interest rates. Government fiscal policy Taxation Monetary policy State of the economy

Copyright © 2000 by Harcourt, Inc. All rights reserved I'I' Interest Rate (%) I*I* Loanable Funds ($) 0 S LF D LF D LF' Higher D LF 0 Interest Rate (%) I*I* I'I' Loanable Funds ($) S LF D LF D LF' Lower D LF SHIFTS IN DEMAND CURVES AND CHANGES IN THE EQUILIBRIUM RATE OF INTEREST If the demand for loanable funds increases, the equilibrium interest rate will increase. If the demand for loanable funds decreases, the equilibrium interest rate will fall.

Copyright © 2000 by Harcourt, Inc. All rights reserved Fisher Effect Inflation affects real purchasing power. Investors will demand a higher interest rate (an inflation premium) for expected lost purchasing power over the period of an investment.

Copyright © 2000 by Harcourt, Inc. All rights reserved Fisher effects i N = the nominal rate demanded i R = the real rate of return desired If the real rate of return desired is 2% and expected inflation is 12%, then the nominal rate demanded is: (1.02)(1.12) - 1 =.142 or 14.2%.

Copyright © 2000 by Harcourt, Inc. All rights reserved The real ex post return that investors actually get is given by If inflation turned out to be 12%, and the nominal rate was 14.2%, the real ex post return would be: (1.142)/(1.12) - 1 =.02 or 2%.

Copyright © 2000 by Harcourt, Inc. All rights reserved The Fisher effect approximation formula eliminates the cross-products. The Fisher effect assumes that the i R remains unchanged. Changes in nominal interest rates are driven by changes in expected inflation.

Copyright © 2000 by Harcourt, Inc. All rights reserved Interest Rates (%) iN*iN* iN'iN' D LF ' D LF S LF ' S LF Loanable Funds ($) Increases in inflation will cause savers to demand a higher rate of return for every quantity of loanable funds supplied. Supply curve shifts left. Borrowers are willing to pay the higher nominal rate, realizing that they will repay their loans with “cheaper dollars”. Demand curve shifts right. INFLATION AND THE EQUILIBRIUM RATE OF INTEREST

Copyright © 2000 by Harcourt, Inc. All rights reserved Evaluation of the Fisher Effect The theory is based on ex ante real rates and ex ante expected inflation which are not observable, resulting in measurement problems in testing the theory. Ex post real rates are not stable which suggests that inflationary expectations by investors were consistently incorrect.

Copyright © 2000 by Harcourt, Inc. All rights reserved Income taxes are levied on nominal rather than on real returns. This suggests that changes in nominal yields will actually be greater than that predicted by Fisher to compensate for the tax on the inflation premiums. The nominal rate adjusting for tax effects

Copyright © 2000 by Harcourt, Inc. All rights reserved Interest Rate Forecasting Many variables must be considered before rates can be predicted, and each variable is a possible source of error. Forecasters must estimate several different rates. The loanable funds framework is widely used by professional forecasters. Example: Salomon Brothers’ annual Prospects for the Credit Markets.

Copyright © 2000 by Harcourt, Inc. All rights reserved Coupon Equivalent Yield on Money Market Securities where: P 0 =the initial amount invested Par =the par value at maturity P 1 =price received if sold before maturity n =the number of days until maturity or sold

Copyright © 2000 by Harcourt, Inc. All rights reserved Effective Annual Yield The equation implicitly assumes that any money received will be reinvested at the given annual rate during the year, resulting in a higher effective rate of return at the end of the year. Hence, y * will be greater than y.

Copyright © 2000 by Harcourt, Inc. All rights reserved Bank Discount Yield The yield on money market securities is quoted as a percentage of par. Thus, discount yield (d) will always be lower than the annual yield (y) or the effective annual rate (y * ).

Copyright © 2000 by Harcourt, Inc. All rights reserved The purchase price of money market securities is found by:

Copyright © 2000 by Harcourt, Inc. All rights reserved Find the price, the coupon equivalent yield and the effective annual yield for a 91-day T-bill with a discount yield of 4.425%. Purchase price of the T-bill 98.8% of par The price that must be paid for the T-bill with a par value of $10,000 would be $9,

Copyright © 2000 by Harcourt, Inc. All rights reserved Coupon equivalent (annual) yield for the T-bill or 4.539% The effective annual yield for the T-bill or 4.618%

Copyright © 2000 by Harcourt, Inc. All rights reserved Interest-bearing Money Market Instruments where: P 1 = the amount received at maturity, equal to interest earned at the quoted rate plus the principal or amount invested d = the quoted rate

Copyright © 2000 by Harcourt, Inc. All rights reserved Find the effective annual yield on a 180-day CD with a face value of $1 million and a coupon rate of 3.5%. Amount received at maturity $ million The effective annual yield on the CD or 3.581%

Copyright © 2000 by Harcourt, Inc. All rights reserved Differences in Yields for Money Market Securities Default risk Liquidity Influenced by the size of the secondary market for the particular security. Denomination size Maturity

Copyright © 2000 by Harcourt, Inc. All rights reserved Currency Exchange Rates Exchange rate risk results from the variability in the rate at which one currency can be converted into another currency. Spot exchange rates are the rates for immediate exchange between currencies. Quoting conventions U.S. $ equivalent or direct rate is the dollars per unit of foreign currency. Currency per U.S. $ or indirect rate is the units of foreign currency per U.S. $.

Copyright © 2000 by Harcourt, Inc. All rights reserved Forward exchange rates are rates which are agreed upon today for currency exchanges that will occur in the future. Forward exchange is an agreement between two parties to exchange a specific amount of currency for another at a specific future date and at a specific rate of exchange. The forward rate agreed on may differ from the spot rate at the time of negotiation and from the spot rate at time of exchange.

Copyright © 2000 by Harcourt, Inc. All rights reserved Theories of Exchange Rate Determination Supply and Demand for Goods and Services An increase (decrease) in the demand for a country’s goods and services should lead to an appreciation (depreciation) in the value of that country’s currency, assuming no changes in the price level.

Copyright © 2000 by Harcourt, Inc. All rights reserved Purchasing Power Parity Theorem Relatively high inflation in one country will be accompanied by a depreciation of its currency relative to currencies in countries with lower inflation rates. Interest Rate Parity Theorem Higher interest rates in a country will lead to an appreciation of its currency.

Copyright © 2000 by Harcourt, Inc. All rights reserved Suppose a U.S. bank agreed on August 24th, 1998 to finance a U.S. importer of Swiss chocolates. The cost of the imported chocolates in Swiss francs (SF) was 25 million; the exporter agreed to pay back the loan in SF on November 2, Determine the exchange rate exposure of the bank. Direct spot rate on August 24, 1998 = $ Direct spot rate on November 2, 1998 = $ U.S bank lending commitment in August: SF 25 million × = $16.66 million.

Copyright © 2000 by Harcourt, Inc. All rights reserved Amount paid by the importer to the bank on November 2nd: SF25 million ×.7402 = $ million. The bank benefited from a rise in SF relative to the dollar, receiving $1.845 million more than it lent out. To remove the uncertainty about the dollar commitment, the bank could have entered into a 60- day forward agreement on August 24th. If the direct forward rate was.6710, the bank would have received $ million in November.