THE LEVEL OF INTEREST RATES

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CHAPTER 4

• THE LEVEL OF INTEREST RATES

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What are Interest Rates?

• Rental price for money.
• The time value of consumption.
• Opportunity cost.
• Expressed in terms of annual rates.
• As with any price, interest rates serve to
  allocate funds to alternative uses.
• Allocate funds between surplus spending units and
  deficit spending units and between financing
  markets

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The Real Rate of Interest

• There is a preference for "real" applications for
  savings such as consumption or real investment.
• People may prefer to consume goods today rather
  than tomorrow - Positive Time Preference
• Real interest rate compensates for delayed
  consumption or giving up real investment
  opportunities.
• The higher the desire for consumption or real
  investment opportunities, the higher the real
  rate of interest.

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The Real Rate of Interest - Continued

• The real rate of interest is the fundamental
  long-run rate in the economy
• It is where the savings curve crosses the desired
  investment curve
• Typically, it is between 2 and 4 percent in the
  U.S. economy. I believe it is below 2 percent
  now.

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The Real Rate of Interest - Continued

• Interest rate paid on savings depend on
• The rate of return producers can expect to earn
  on investment capital
• Return on investment
• Savers time preference for current versus future
  consumption
• U.S. Treasury I Bonds
• I Bond Interest Rates
• Note that the fixed rate is now 1.00 for bond
  issued from Nov. 1, 2004 to April 30, 2005

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The Real Rate of Interest (concluded)

• The real rate of interest is determined by the
  demand and supply for savings at a given point in
  time.
• The real rate is the price needed to delay
  consumption of funds demanded for real
  investment.
• Upward shifts to the right (increases) in demand
  for desired real investment cause the real rate
  of interest to increase.
• If the supply of desired savings shifts
  (increases) to the right, the real rate of
  interest declines.

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Determinants of theReal Rate of Interest
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Treasury Inflation Protection Securities - TIPS

• On January 29, 1997, 7 billion of U.S. Treasury
  Inflation Protection Securities were issued.
• They were oversubscribed by more than five times.
  
• The Treasury set the yield, which was determined
  by demand, at a lower than expected 3.448.
• That amount was tacked on to the rate of
  inflation during the 10 year life of the notes.

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Loanable Funds Theory of Interest

• The level of interest rates is determined by the
  supply and demand for loanable funds.
• The real rate of interest is the long-term base
  rate of interest.
• Short-run supply/demand factors and financial
  market risks affect nominal interest rates.
• The quantity demanded of loanable funds, DL, is
  inversely related to the level of interest rates
  the quantity supplied (SL) is directly related to
  interest rates. Please see Exhibit 4.3 on page 89
  of your text and on slides 12 through 15.

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Loanable Funds Theory of Interest (concluded)

• DSUs demand loanable funds for home building,
  plant/equipment, and inventory financing. They
  issue financial claims in excess of their current
  income.
• The supply of loanable funds available for
  financial investment may come from decreasing
  money balances or past savings.
• In equilibrium, SL DL.

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Supply/Demand Sources

• Notice that households, businesses, and
  governmental units are both suppliers and
  demanders of loanable funds. During most periods,
  households are net suppliers of funds, whereas
  the federal government is almost always a net
  demander of funds.
• Supply of Loanable Funds (SSU)
• Consumer savings
• Business savings (depreciation and retained
  earnings)
• State and local government budget surpluses
• Federal government budget surplus (if any)
• Federal Reserve increases the money supply (?M)
• Demand for Loanable Funds (DSU)
• Consumer credit purchases
• Business investment
• Federal government budget deficits
• State and local government budget deficits

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Loanable Funds Theory
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Loanable Funds Theory
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Loanable Funds Theory
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Loanable Funds Theory
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Price Expectations andInterest Rates

• Expected inflation, ex ante, is embodied in
  nominal interest rates -- The Fisher Effect.
• Investors want compensation for expected
  decreases in the purchasing power of their
  wealth.
• If investors feel the prices of real goods will
  increase (inflation), it will take increased
  interest rates to encourage them to place their
  funds in financial assets.

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Fisher Effect

• The formula for the Fisher equation is

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Fisher Effect - continued

• From the Fisher equation, with a little algebra,
  we see that the nominal (contract) rate is
• From this equation we see that a lender gets
  compensated for
• rent on money loaned,
• compensation for loss of purchasing power on the
  principal,
• compensation for loss of purchasing power on the
  interest.

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Fisher Effect (continued)

• Contract rate example for 1-year 1000 loan when
  the loan parties agree on a 3 rental rate for
  money and a 5 expected rate of inflation.
• Items to pay Calculation Amount
• 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

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Price Expectations andInterest Rates

• Actual realized ex-post rates of return reflect
  the impact of inflation on past investments or on
  investors.
• r i - ?Pa, where the annual "realized" rate of
  return from past securities purchases, r, equals
  the annual nominal rate minus the actual annual
  rate of inflation.
• With ever-increasing rates of inflation,
  investors' inflation premiums, Pe, may lag actual
  rates of inflation, Pa, yielding low or even
  negative actual real rates of return.

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Nominal/Realized Rates
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Impact of Inflation on Loanable Funds Theory of
Interest
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Interest Rate Changes and Changes in Inflation
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Interest Rate Changes and Changes in Inflation
(concluded)

• What do we learn from the previous slide?
• Interest rates change with changes in inflation.
• Short-term interest rates change more than
  long-term interest rates for a given change in
  inflation.

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Economies with High, Persistent Inflation

• Very few, if any, long-term debt instruments are
  used.
• Complete reliance on debt instruments with
  floating interest rates rather than fixed rates
• There is not much long-term financing (more than
  one year) available
• Please read the section on interest rates in
  Poland in the early 1990s (page 92).
• Use of another currency, such as the U.S. dollar

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The Term Structure of Interest Rates January 28,
2005
Source Bloomberg Web Site http//www.Bloomberg.c
om/markets/C13.html
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Term Structure Formula from Expectation Theory
(Chapter 6)
Please use this formula in solving question 5 at
the end of the Chapter 4.
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Conclusion

• Role of Interest Rates
• Real Rate of Interest
• Loanable Funds Theory
• Fisher Effect
• Changes in Inflation
• Term Structure of Interest Rates