1. 1 Chapter 7 Interest Rates and Bond Prices © 2000 South-Western College Publishing

2. 2 Time Value of Money The terms on which one can trade off present purchasing power for future purchasing power; the interest rate

3. 3 Compounding A method used to determine the future value of a sum lent today

4. 4 Principal is... The original amount of funds lent

5. 5 Compounding the Future Value of Money Lent Today Exhibit 7.1 Payment Today $1,000 Future Value $1,060

6. 6 DISCOUNTING A method used to determine the present value of a sum to be received in the future

7. 7 PRESENT VALUE The value today of funds to be received or lent on a future date

8. 8 Value Today $1,000 Future Payment $1,060 Discounting: The Present Value of Money to Be Received in the Future Exhibit 7.2

9. 9 PAR VALUE The face value printed on a bond; the amount the bond originally sold for

10. 10 COUPON PAYMENTS The periodic payments made to bondholders, which are equal to the principal times the coupon rate

11. 11 Discount From Par When a bond sells below its face value because interest rates have increased since the bond was originally issued

12. 12 YIELD TO MATURITY The return on a bond held to maturity, which includes both the interest return and any capital gain or loss

13. 13 Premium Above Par When a bond sells above its face value because interest rates have decreased since the bond was originally issued

14. 14 The demand for loanable funds... The demand for borrowed funds by household, business, government or foreign DSUs

15. 15 $500 E1E1 Interest Rate (percent) Loanable Funds (in billions) 6 Supply The Supply of and Demand for Funds Exhibit 7.3 Demand

16. 16 Supply of Loanable Funds The supply of borrowed funds originating from (1) household, business, government, or foreign SSUs, or (2) the Fed in its provision of reserves in the conduct of monetary policy

17. 17 E1E1 Interest Rate (percent) Loanable Funds (in billions) 6 SS A Shift in the Demand for Funds Exhibit 7.4 DD D E2E2 8 $500$600

18. 18 Interest Rate (percent) Loanable Funds (in billions) 4 SS A Shift in the Supply for Funds Exhibit 7.5 DD 6 $500$550 S E1E1 E2E2

19. 19 Nominal Interest Rate The market interest rate, or the real return plus the rate of inflation expected to prevail over the life of the asset

20. 20 Real Interest Rate The interest rate corrected for changes in the purchasing power of money; the nominal interest rate minus the expected rate of inflation

21. 21 MONEY ILLUSION When spending units react to nominal changes caused by changes in prices, although real variables such as interest rates have not changed

22. 22 INFLATION PREMIUM The amount of nominal interest added to the real interest rate to compensate the lender for the expected loss in purchasing power that will accompany any inflation

23. 23 Recessions Inflation Rate (percent) 6 -month Commercial Paper Rate (percent) Inflation and Interest Rates Percent 1960’65’70’75’80’85’90’952000 0 5 10 15 Figure 7.6

24. 24 Interest Rate (percent) Loanable Funds (in billions) 4 SS Inflation and Interest Rates: A Graphical Treatment Exhibit 7.7 DD 10 $500 S E1E1 E2E2 D

25. 25 Dividends Profits distributed to stockholders

26. 26 A consol is... A perpetual bond with no maturity date; the issuer is never obliged to repay the principal but makes coupon payments each year forever