1. THE LEVEL OF INTEREST RATES
CHAPTER 4
THE LEVEL OF INTEREST RATES

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 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.

3. 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.

4. 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.

5. 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.

6. 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.

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

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.

13. 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.

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

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

16. 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.

17. 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.

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

19. 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.

20. 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%
PP loss on principal $1,000 x 5%
PP loss on interest $1,000 x 3% x 5%
Total Compensation $1,081.50
Copyright© 2006 John Wiley & Sons, Inc.

21. 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.

22. 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 Ch. 4

23. 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.

24. 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.