1. 1 CHAPTER 5 Interest Rate Determination © Thomson/South-Western 2006

2. 2 Interest Rates The price paid for borrowing funds, expressed as a percent per year. or The price received for lending of funds, expressed as a percent per year.

3. 3 Interest Rates (2) Interest rates are important because they affect: the level of consumer expenditures on durable goods; investment expenditures on plant, equipment, and technology; the way that wealth is redistributed between borrowers and lenders; the prices of such key financial assets as stocks, bonds, and foreign currencies;

4. 4 Interest Rates (3) the monthly payments on households’ car loans and home mortgages, and income earned by households on savings accounts, certificates of deposit, various types of bonds, and money market mutual fund shares. For our purposes, “interest rate” and “yield” are used interchangeably.

5. 5 Real and Nominal Interest Rates The nominal interest rate is the stated or actual interest rate, unadjusted for inflation. The real interest rate is the nominal interest rate adjusted for inflation. The real interest rate is the actual interest rate that would prevail in a hypothetical world of zero inflation.

6. 6 Present Value: Interest Rates And Security Prices Present Value (PV), Interest Rates(i), and Securities Prices interrelate. The present value is the discounted value of a payment (or stream of payments) to be received at some point in the future. Simple one-year present value: PV = FV / (1+i)

7. 7 Present Value: Interest Rates And Security Prices (2) The future value is the interest-adjusted value of a payment (or payments) to be made now (or in the future) at some point in the future. Simple one-year future value : FV = PV (1+ i) The price of any security is the present value at a given interest rate of the future payments expected to be made by the security issuer PV (or price) = R 1 /(1+i) + R 2 / (1+i) 2 + R 3 / (1+i) 3 + … + R n / (1+i) n

8. 8 Fig 5-1

9. 9 Interest Rates and Security Prices Interest rates and bond (or any debt instrument) prices are inversely related. Interest rate increases, decrease bond prices (PV). Interest rate decreases, increase bond prices (PV). At interest rate, i, a bond that pays F at maturity with coupon payments C 1, C 2, C 3, …,C n is worth PV = C 1 /(1+i) + C 2 /(1+i) 2 + C 3 (1+i) 3 + … + (C n + F) / (1+i) n

10. 10 The Loanable Funds Model Of Interest Rates Economists and financial analysts use the loanable funds model to forecast interest rates. The interest rate is the price paid for the right to borrow and use loanable funds. Borrowers demand funds, Savers supply funds.

11. 11 Individual Sources of Supply and Demand for Loanable Funds in the United States Sources of Supply personal saving business saving government budget surplus bank loans foreign lending in the U.S.

12. 12 Individual Sources of Supply and Demand for Loanable Funds in the United States Sources of Demand household credit purchases business investment spending government budget deficit foreign borrowing in the U.S.

13. 13 Figure 5-2

14. 14 The Loanable Funds Model The interest rate: is the reward for saving; works to counteract the human trait of time preference. Supply slopes upward. Household saving is relatively insensitive to the interest rate. Bank lending varies directly with the interest rate because profit-maximizing banks more aggressively seek out and grant loans as rates rise. Holding foreign interest rates constant, an increase in U.S. rates attracts additional funds to U.S. financial markets from abroad.

15. 15 The Loanable Funds Model Demand slopes downward. Lower car/home/furniture loan rates reduce monthly payments, thereby increasing these items’ affordability. Lower rates induce investment in plant, equipment, inventories, and non-residential real estate. Lower interest rates in the United States induce foreigners to step up borrowing in the U.S.

16. 16 The Loanable Funds Model The interest rate is the price paid for the right to borrow & use loanable funds. Borrowers = demand Savers = supply

17. 17 The Loanable Funds Model The interest rate is the price paid for the right to borrow & use loanable funds. Borrowers = demand Savers = supply

18. 18 Factors Shifting Supply and Demand for Loanable Funds Inflation Expectations Federal Reserve Policy The Business Cycle Federal Budget Deficits (Surpluses)

19. 19 Inflation Expectations Interest rates rise in periods during which people expect inflation to increase. Interest rates typically fall when people expect inflation to decline. Nominal Interest rate = Real Interest rate + Inflation Fisher Effect

20. 20 Inflation Expectations (2) The loanable funds framework easily explain this: People are less willing to lend funds because they expect the real value of the principal loaned out to erode more rapidly if inflation increases. People are much more willing to borrow because they expect the real value of the debt incurred to fall more rapidly as inflation rises.

21. 21 Inflation Expectations (3) People are less willing to lend because they expect the real value of the principal to decline  supply shifts left People are much more willing to borrow (rather spend now than later)  demand shifts right

22. 22 Federal Reserve Policy To stimulate the economy, the Fed encourage banks to expand loans, boosting the money supply  supply curve shifts right  interest rate  To restrain economic activity, the Fed force banks to reduce their lending, limiting the money supply  supply curve shifts left  interest rates  The Fed has more direct influence on short-term interest

23. 23 The Business Cycle Interest rates have been strongly pro-cyclical: rising during the expansion falling during the contraction This pattern is most evident in short-term interest rates.

24. 24 The Business Cycle (2) During expansion phase: Demand for funds  (consumption, investment) Demand for products   Inflation  Fed tries to slow down the growth: tight monetary policy During recession phase: Demand for funds  (consumption, investment) Demand for products   Inflation  Fed tries to boost up the growth: ease monetary policy

25. 25 Federal Budget Deficits (or Surpluses) Intuitively, an increase in the federal budget deficit should raise interest rates. An increase in borrowing by the federal government implies a rightward shift in the demand curve for loanable funds. Most economists agree that deficits lead to higher interest rates.

26. 26 Federal Budget Deficits (or Surpluses) Gov borrowing   demand shifts right  interest  Gov spending   inflation   interest rate 