CHAPTER 4

THE LEVEL OF
INTEREST RATES
Copyright 2012 John Wiley & Sons, Inc.

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.

The Real Rate of Interest

Producers 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.

Determinants of the Real Rate of Interest

Copyright 2012 John Wiley & Sons, Inc.

Loanable Funds Theory

Supply of loanable funds
All sources of funds available to invest in financial
claims

Demand for loanable funds

All uses of funds raised from issuing financial claims

Equilibrium interest rate

Copyright 2012 John Wiley & Sons, Inc.

Supply of loanable funds

All sources of funds available to invest in

financial claims:
Consumer savings
Business savings
Government budget surpluses
Central Bank action

Copyright 2012 John Wiley & Sons, Inc.

Demand for Loanable Funds

All uses of funds raised from issuing
financial claims:
Consumer credit purchases
Business investment
Government budget deficits

Copyright 2012 John Wiley & Sons, Inc.

Equilibrium Interest Rate

If 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.

Loanable Funds Theory

Copyright 2012 John Wiley & Sons, Inc.

Loanable Funds Theory

Copyright 2012 John Wiley & Sons, Inc.

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Loanable Funds Theory

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Loanable Funds Theory

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Price Expectations and Interest Rates

Unanticipated 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.

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Fisher Effect
The exact Fisher equation is:

1 i 1 r 1 Pe
where
i the observed nominal rate of interest,
r the real rate of interest,
Pe the expected annual rate of inflation.

Copyright 2012 John Wiley & Sons, Inc.

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Fisher Effect, cont.

From the Fisher equation, we derive the nominal
(contract) rate:

i r Pe r * Pe

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.

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Fisher Effect: Example

1-year $1000 loan
Parties agree on 3% rental rate for money and
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

Copyright 2012 John Wiley & Sons, Inc.

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Simplified Fisher Equation

The third term in the Fisher equation is

negligible, so it is commonly dropped. The
resulting equation is

i r Pe

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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.
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Impact of Inflation under Loanable Funds Theory

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Interest Rate Movements and Inflation

Historically, 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.

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Negative Interest Rates

Negative interest rates in Japan

Negative interest rates on US Treasury
securities

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Forecasting Interest Rates

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