Power Point Slides for:
Financial Institutions, Markets, and
Money, 9th Edition
Authors: Kidwell, Blackwell, Whidbee &
Peterson
Prepared by: Babu G. Baradwaj, Towson University
And
Lanny R. Martindale, Texas A&M University
Copyright© 2006 John Wiley & Sons, Inc.
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CHAPTER 4
THE LEVEL OF
INTEREST RATES
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© 2006 John Wiley & Sons, Inc.
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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© 2006 John Wiley & Sons, Inc.
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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© 2006 John Wiley & Sons, Inc.
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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© 2006 John Wiley & Sons, Inc.
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Demand for Loanable Funds
All uses of funds raised from issuing
financial claims:
Consumer credit purchases
Business investment
Government budget deficits
Copyright© 2006 John Wiley & Sons, Inc.
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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© 2006 John Wiley & Sons, Inc.
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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© 2006 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.
As inflation increases, expected inflation
premiums, Pe, may lag actual rates of inflation,
Pa, yielding low or even negative actual returns.
Copyright© 2006 John Wiley & Sons, Inc.
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Copyright© 2006 John Wiley & Sons, Inc.
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Copyright© 2006 John Wiley & Sons, Inc.
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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.
Copyright© 2006 John Wiley & Sons, Inc.
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