ch04.ppt-level of interest rates
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financeTRANSCRIPT
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CHAPTER 4THE LEVEL OF INTEREST RATESCopyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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*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 to allocate resources.Copyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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*The Real Rate of InterestProducers seek financing for real assets. Expected ROI is upper limit on interest rate producers can pay for financing.
Savers require compensation for deferring consumption. 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 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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*Determinants of the Real Rate of InterestCopyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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*Loanable Funds TheorySupply of loanable fundsAll sources of funds available to invest in financial claims
Demand for loanable fundsAll uses of funds raised from issuing financial claims
Equilibrium interest rateCopyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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Supply of loanable funds
All sources of funds available to invest in financial claims:Consumer savingsBusiness savingsGovernment budget surplusesCentral Bank action
Copyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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*Demand for Loanable FundsAll uses of funds raised from issuing financial claims:Consumer credit purchasesBusiness investmentGovernment budget deficits
Copyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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*Equilibrium Interest RateIf 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 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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*Loanable Funds TheoryCopyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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*Loanable Funds TheoryCopyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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*Loanable Funds TheoryCopyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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*Loanable Funds TheoryCopyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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*Price Expectations and Interest RatesUnanticipated inflation benefits borrowers at expense of lenders.
Lenders charge added interest to offset anticipated decreases in purchasing power.
Expected inflation is embodied in nominal interest rates: The Fisher Effect.Copyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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*Fisher EffectThe exact Fisher equation is:Copyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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*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.
Copyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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*Fisher Effect: Example1-year $1000 loan Parties agree on 3% rental rate for money and 5% expected rate of inflation.
Items to payCalculationAmountPrincipal $1,000.00Rent on money$1,000 x 3% 30.00PP loss on principal$1,000 x 5% 50.00PP loss on interest$1,000 x 3% x 5% 1.50Total Compensation $1,081.50Copyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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*Simplified Fisher EquationThe third term in the Fisher equation is negligible, so it is commonly dropped. The resulting equation is Copyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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*Copyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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*Expectations ex ante v. Experience ex post
Realized rates of return reflect impact of inflation on past investments.
r = i - Pa, where the "realized" rate of return from past transactions, r, equals the nominal rate minus the actual annual rate of inflation.
As inflation increases, expected inflation premiums, Pe, may lag actual rates of inflation, Pa, yielding low or even negative actual returns.Copyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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*Copyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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*Impact of Inflation under Loanable Funds TheoryCopyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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*Copyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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*Interest Rate Movements and InflationHistorically, 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 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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Negative Interest Rates
Negative interest rates in Japan
Negative interest rates on US Treasury securities*Copyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.
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Forecasting Interest Rates*Copyright 2012 John Wiley & Sons, Inc.
Copyright 2012 John Wiley & Sons, Inc.