CHAPTER 5 Interest Rate Determination ©Thomson/South-Western 2006 Interest Rates Interest rates are important because they affect: the level of consumer expenditures on durable.
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Transcript CHAPTER 5 Interest Rate Determination ©Thomson/South-Western 2006 Interest Rates Interest rates are important because they affect: the level of consumer expenditures on durable.
CHAPTER 5
Interest Rate
Determination
©Thomson/South-Western 2006
1
Interest Rates
Interest rates are important because they affect:
the level of consumer expenditures on durable goods;
investment expenditures on plant, equipment, and
technology;
the way that wealth is redistributed between borrowers
and lenders;
the prices of such key financial assets as stocks, bonds,
and foreign currencies;
the monthly payments on households’ car loans and home
mortgages, and
income earned by households on savings accounts,
certificates of deposit, various types of bonds, and money
market mutual fund shares.
For our purposes, “interest rate” and “yield” are used
interchangeably.
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Real and Nominal Interest Rates
The nominal interest rate is the stated
interest rate, unadjusted for inflation.
The real interest rate is the nominal interest
rate adjusted for inflation.
The real interest rate is the actual interest rate
that would prevail in a hypothetical world of
zero inflation.
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Present Value: Interest Rates
And Security Prices
Present Value (PV), Interest Rates(i), and Securities
Prices interrelate.
The present value is the discounted value of a
payment (or stream of payments) to be received at
some point in the future.
Simple one-year present value: PV = FV / (1+i)
The future value is the interest-adjusted value of a
payment (or payments) to be made now (or in the
future) at some point in the future.
Simple one-year future value: FV = PV (1+ i)
The price of any security is the present value at a
given interest rate of the future payments expected
to be made by the security issuer
PV (or price) = R1/(1+i) + R2 / (1+i)2 + R3 / (1+i)3 + … + Rn / (1+i)n
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Fig 5-1
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Interest Rates and Security
Prices
Interest rates and bond (or any debt instrument) prices are
inversely related.
Interest rate increases decrease bond prices (PV).
Interest rate decreases increase bond prices (PV).
At interest rate, i, a bond that pays F at maturity with coupon
payments C1, C2, C3, …,Cn is worth
PV = C1/(1+i) + C2/(1+i)2 + C3(1+i)3 + … + (Cn+ F) / (1+i)n
Suppose a 5%, 5-year bond pays $1000 at maturity with
annual coupons of $50.
If interest rates rise to 6% then price falls to $965.34
$50/1.06 + $50/(1.06)2 + $50/(1.06)3 + ($50 + $1,000) /
(1.06)4
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The Loanable Funds Model Of
Interest Rates
Economists and financial analysts use the
loanable funds model to forecast interest
rates.
The interest rate is the price paid for the right to
borrow and use loanable funds.
Borrowers demand funds,
Savers supply funds.
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Individual Sources of Supply and Demand
for Loanable Funds in the United States
Sources of Supply
personal saving
business saving
government budget surplus
bank loans
foreign lending in the U.S.
Sources of Demand
household credit purchases
business investment spending
government budget deficit
foreign borrowing in the U.S.
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Figure 5-2
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The Loanable Funds Model
The interest rate:
is the reward for saving;
works to counteract the human trait of time preference.
Supply slopes upward.
Household saving is relatively insensitive to the interest rate.
Bank lending varies directly with the interest rate because profitmaximizing banks more aggressively seek out and grant loans as rates
rise.
Holding foreign interest rates constant, an increase in U.S. rates attracts
additional funds to U.S. financial markets from abroad.
Demand slopes downward.
Lower car/home/furniture loan rates reduce monthly payments, thereby
increasing these items’ affordability.
Lower rates induce investment in plant, equipment, inventories, and nonresidential real estate.
Lower interest rates in the United States induce foreigners to step up
borrowing in the U.S.
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Factors Shifting Supply and
Demand for Loanable Funds
Inflation Expectations
Federal Reserve Policy
The Business Cycle
Federal Budget Deficits (Surpluses)
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Inflation Expectations
Interest rates rise in periods during which people
expect inflation to increase.
Interest rates typically fall when people expect
inflation to decline.
The loanable funds framework can easily explain this:
People are less willing to lend funds because they
expect the real value of the principal loaned out to
erode more rapidly if inflation increases.
People are much more willing to borrow because
they expect the real value of the debt incurred to
fall more rapidly as inflation rises.
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The Fisher Hypothesis
A formula linking nominal (actual) interest rates and
expected inflation:
i = r + e
e represents the expected inflation rate
is the extent to which nominal interest rates adjust to each one
percentage-point increase in the expected inflation rate
The Fisher Hypothesis:
strong form: =1 inflation neutrality
weak form: >0
Economists agree that inflation expectations powerfully influence
the level of interest rates, especially long-term rates.
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The Fundamental Forces Driving
Real Interest Rates
Marginal productivity of capital:
rate of return expected by firms from purchase of
an additional unit of capital goods
Rate of time preference:
extent to which people prefer present goods over
future goods
Federal Reserve policies
The federal government budget
Business cycle conditions
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Empirical Evidence on the Fisher
Hypothesis
Empirical research indicates that the
sensitivity of interest rates to inflation appears
to have increased sharply in the post-World
War II era.
Before the 1940s, financial markets do not appear
to have responded to inflation.
In the past 50 years, interest rates have exhibited
a definite sensitivity to the outlook for inflation.
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Federal Reserve Policy
To stimulate the economy, the Fed implements measures
that:
encourage banks to expand loans,
thereby boosting the money supply moving the
supply curve of loanable funds rightward, which
reduces interest rates.
To restrain economic activity, the Fed implements actions
that:
force banks to reduce their lending,
thereby curtailing the money supply, moving the
supply curve of loanable funds leftward and thus
driving up interest rates.
The Federal Reserve has considerably more direct influence
on short-term interest rates than on long-term rates.
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The Business Cycle
Interest rates have historically been strongly
pro-cyclical:
rising during the expansion phase of the business
cycle and
falling during periods of economic contraction.
This pattern is most evident in short-term interest
rates.
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Federal Budget Deficits (or
Surpluses)
Intuitively, an increase in the federal budget deficit should raise interest
rates.
An increase in borrowing by the federal government implies a rightward shift
in the demand curve for loanable funds.
Most economists agree that deficits lead to higher interest rates.
Some disagree and argue:
that the size of the U.S. deficit is small in relation to the total pool of
worldwide financial capital, and
that a relationship between the federal budget deficit and saving
behavior of individuals interferes with any such direct relationship
between the size of the budget deficit and interest rates.
The Ricardian Equivalence proposition suggests that people will offset
deficits with greater savings to pay future taxes.
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Major Interest Rate Movements,
1960-2003
1960-1965
Low inflation, low bond yields.
1965-1981
Vietnam(66-69), oil price shocks (73-79), rapid inflation (78-80),
Fed policy increased interest rates to eradicate inflation (80-81)
1980-2003
inflation fell, expected inflation Fell
worldwide recession (81-83)
moderate inflation (82-90)
sluggish recovery from 1990 recession->low short term interest rates
low inflation (91-2000)
low long and short term rates (00-03)
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Real Interest Rates: Ex Ante vs
Ex Post
Expected or ex ante real rate
r ex ante = i - e
Realized or ex post real rate
r ex post = i -
The expected or ex ante real interest rate is of
CRITICAL importance because investors act
upon this information.
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Two Measures of Ex Ante Real
Interest Rates
Before Tax
r = i - e
After Tax
rat = i (1-t) - e
Where t is the marginal income tax rate
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The Historical Behavior of
Expected Real Interest Rates
The expected real interest rate is not constant
over time.
1970s low
1980s high
1990s intermediate
2000-2004 very low (some negative)
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The High Rates of the 1980s
The Fed maintained tight money policies in
1980-81.
Large federal budget deficits emerged after
1981 (tax cuts and defense buildup).
Pro-business policies (cuts in business taxes,
deregulatory actions), increased the expected
returns from capital expenditures, boosting
demand for funds by business.
Lower real energy prices increased demand
for energy intensive capital goods.
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1970s
Low Real Rates of the 1970s
and 2000s
stimulative monetary policy
expected returns from capital goods were low
small budget deficits
1995-2000
technological innovations in information systems,
telecommunications, and other areas led to a sharp increase in the
expected returns from capital
major swing from large federal budget deficits to large surpluses
relatively low inflation made possible by surging productivity and a
strong U.S. dollar internationally
stimulative monetary policy
2001-2004
stimulative monetary policy
recession
low business and consumer confidence
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