1. The Determination of Interest Rates

2. I. Determinants of the Interest Rate Level A. Real Rate of Interest Definitions –Interest Rate: The price paid for the use of money. –Nominal Rate: The interest rate expressed in terms of nominal dollars. –Real Rate:The interest rate expressed in terms of real dollars.

3. Equilibrium Real Rate –Supply of Funds (e.g., propensity of household to save) –Demand for Funds (e.g., expected productivity of capital)

4. B. Macroeconomic Factors Economic Growth Rate of Inflation (1 + r)(1 + i) = (1 + R), where r = real rate, i = inflation rate, and R = Nominal rate.

5. Fisher Equation R = r + E(i) The nominal rate equals to the real rate plus the expected rate of inflation.

6. Money Supply Taxes and Government Spending R(1-t) - i = (r + i)(1 - t) - i = r(1 - t) - it. The real after-tax rate is approximately the after-tax nominal rate minus the rate of inflation. Foreign Flow of Funds

7. C. Microeconomic Factors Default Risk Administrative Costs Maturity Liquidity Special Provisions (Callability, Convertibility)

8. II. Theory of Interest Rate A. Interest Rate Structure B. Theories The Liquidity Preference Theory –Demand for Money –Supply of Money Loanable Funds Theory –Demand for Loanable Funds –Supply of Loanable funds

9. III. Interest Rates Over Time 1973Inflation caused by the energy crisis 1973-4Recession 1980Inflation caused by strong economic growth 1982Recession 1989Capital flow caused by a unified Germany 1990Recession 1994Economic Expansion 1997Asian Financial Crisis

10. IV. Forecasting Interest Rates ND = D A - S A = [D h + D b + D g + D m + D f ] - [S h + S b + S g + S m + S f ], where ND = net demand for loanable funds, D A = aggregate demand for loanable funds, S A = aggregate supply of loanable funds, D = demand, S = supply, h = household sector,b = business sector, g = government sector,m= money supply, f = foreign sector.