1. Copyright 2014 by Diane Scott Docking 1 Interest Rates Theories... Wasn’t it Ben Franklin who said that???? A fool and his Money are soon Partying!!!!

2. Copyright 2014 by Diane Scott Docking 2 Learning Objectives Know how inflation, expectations, and risk combine to determine interest rates The distinction between real and nominal interest rates The Fisher Effect

3. Copyright 2014 by Diane Scott Docking 3 Interest Rates Defined Interest rates - are a measure of the price paid by a “borrower” (or “debtor”) to a “lender” (or “creditor”) for the use of resources during some time interval.

4. Copyright 2014 by Diane Scott Docking 4 Distinction Between Real and Nominal Interest Rates Inflation and Real Rates Versus Nominal Rates Inflation: measures how the purchasing power of a given amount of currency declines due to growing prices Nominal interest rates: indicates the rate at which your money will grow if invested for a certain period (the stated rate) Real interest rate: the rate of growth of your purchasing power, after adjusting for inflation

5. Copyright 2014 by Diane Scott Docking5 Distinction Between Real and Nominal Interest Rates - Simplified Real interest rate 1. Interest rate that is adjusted for expected changes in the price level 2.Real interest rate more accurately reflects true cost of borrowing 3.When the real rate is low, there are greater incentives to borrow and less to lend

6. Copyright 2014 by Diane Scott Docking6 Example: Distinction Between Real and Nominal Interest Rates - Simplified If i = 5% and π e = 0% then If i = 10% and π e = 20% then

7. Copyright 2014 by Diane Scott Docking 3-7

8. Copyright 2014 by Diane Scott Docking 8 Fisher Effect The exact Fisher equation is:

9. Copyright 2014 by Diane Scott Docking 9 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

10. Copyright 2014 by Diane Scott Docking 10 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 $1,000.00 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 $1,081.50 i =.03+.05+(.03x.05) =.08+.0015=.0815=8.15% P+i$=$1,000x(1.0815)=$1,081.50

11. Copyright 2014 by Diane Scott Docking 11 Simplified Fisher Equation The third term in the Fisher equation is negligible, so it is commonly dropped. The resulting equation is

12. Copyright 2014 by Diane Scott Docking12 Example: Calculating the Real Interest Rate In the year 2000, short-term U.S. government bond rates were about 5.8% and the rate of inflation was about 3.4%. In 2003, interest rates were about 1% and inflation was about 1.9%. What was the real interest rate in 2000 and 2003?

13. Copyright 2014 by Diane Scott Docking13 Example: Calculating the Real Interest Rate Solution: Thus, the real interest rate in 2000 was: In 2003, the real interest rate was: