What are the four most fundamental factors that affect the cost of money, or the general

level of interest rates, in the economy?

1) Production Opportunities – This relates to the opportunities available for investment

in productive assets

2) Time preference for consumption – This relates to the preference for current
consumption or for future consumption

3) Risk – Risk implies that there is a possibility that the investment may produce a lower
or negative return

4) Inflation – The rate of increase in prices over time

b) What is the real risk-free rate of interest (r*) and the nominal-free rate (r RF )? How
are these two rates measured?

1) Real risk free rate refers to the rate on default risk free securities if there was no
inflation. The nominal risk free rate incorporates inflation and so real risk free rate +
inflation

2) The nominal risk free rate is the yield on short term government securities since
these would be default risk free. The real risk free rate is measured by subtracting the
inflation rate from the nominal risk free rate.

C) Define the terms inflation premium (IP), default risk premium (DRP), liquidity
premium (LP), and maturity risk premium (MRP). Which of these premiums is included
in determining the interest rate on (1) short-term U.S. Treasury securities, (2) long-term
U.S. Treasury securities, (3) short-term corporate securities, and (4) long-term
corporate securities? Explain how the premiums would vary over time and among the
different securities listed.