CHAPTER 4 THE LEVEL OF INTEREST RATES

Copyright© 2006 John Wiley & Sons, Inc.2 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 to allocate resources.

Copyright© 2006 John Wiley & Sons, Inc.3 The Real Rate of Interest Producers seek financing for real assets. Expected ROI is upper limit on interest rate producers can pay for financing. Savers require compensation for deferring consumption. 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.4 Determinants of the Real Rate of Interest

Copyright© 2006 John Wiley & Sons, Inc.5 Loanable Funds Theory Supply of loanable funds— All sources of funds available to invest in financial claims Demand for loanable funds— All uses of funds raised from issuing financial claims Equilibrium interest rate

Copyright© 2006 John Wiley & Sons, Inc.6 Supply of loanable funds— All sources of funds available to invest in financial claims: Consumer savings Business savings Government budget surpluses Central Bank Action

Copyright© 2006 John Wiley & Sons, Inc.7 Demand for Loanable Funds All uses of funds raised from issuing financial claims: Consumer credit purchases Business investment Government budget deficits

Copyright© 2006 John Wiley & Sons, Inc.8 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.9 Loanable Funds Theory

Copyright© 2006 John Wiley & Sons, Inc.10 Loanable Funds Theory

Copyright© 2006 John Wiley & Sons, Inc.11 Loanable Funds Theory

Copyright© 2006 John Wiley & Sons, Inc.12 Loanable Funds Theory

Copyright© 2006 John Wiley & Sons, Inc.13 Price Expectations and Interest Rates Unanticipated inflation benefits borrowers at expense of lenders. Lenders charge added interest to offset anticipated decreases in purchasing power. Expected inflation is embodied in nominal interest rates: The Fisher Effect.

Copyright© 2006 John Wiley & Sons, Inc.14 Fisher Effect The exact Fisher equation is:

Copyright© 2006 John Wiley & Sons, Inc.15 Fisher Effect, cont. From the Fisher equation, we derive the 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.16 Fisher Effect: Example 1-year $1000 loan Parties agree on 3% rental rate for money and 5% expected rate of inflation. Items to payCalculationAmount Principal $1, Rent on money$1,000 x 3% PP loss on principal$1,000 x 5% PP loss on interest$1,000 x 3% x 5% 1.50 –Total Compensation $1,081.50

Copyright© 2006 John Wiley & Sons, Inc.17 Simplified Fisher Equation The third term in the Fisher equation is negligible, so it is commonly dropped. The resulting equation is

Copyright© 2006 John Wiley & Sons, Inc.18 Expectations ex ante v. Experience ex post Realized rates of return reflect impact of inflation on past investments. r = i -  P a, where the "realized" rate of return from past transactions, r, equals the nominal rate minus the actual annual rate of inflation. As inflation increases, expected inflation premiums, P e, may lag actual rates of inflation, P a, yielding low or even negative actual returns.

Copyright© 2006 John Wiley & Sons, Inc.19

Copyright© 2006 John Wiley & Sons, Inc.20 Impact of Inflation under Loanable Funds Theory

Copyright© 2006 John Wiley & Sons, Inc.21

Copyright© 2006 John Wiley & Sons, Inc.22 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.