Capital Markets
Interest Rates
• What are some major interest rates in
financial markets? Be as specific as
possible.
Nominal and Real Interest Rates
• Nominal return represents how much money
you will receive after 1 year for giving up 1
dollar of money today
• Real return represents how many goods you
can buy if you give up the opportunity to buy 1
good today.
• Nominal interest rate is money interest rate.
Real interest rate is goods interest rate.
Real Interest Rate
• The real interest rate on the loan is defined as
the future goods received relative to current
goods foregone
$1  i
1  rt 
$1
Pt+1
Pt

$1  i
Pt+1
1
Pt
1  it
1  rt 
 rt  it   t 1
1   t 1
Ex Ante Rate and the Fisher Effect
• Savings and investment decisions must be
made before future inflation is known so they
must be made on the basis of an ex ante
(predicted) real interest rate.
it  rt
EA

FORECAST
t 1
Measuring the Real Interest Rate
•
1.
•
1.
Long-term
Use the yield on inflation protected securities.
Short-term
Use nominal interest minus consensus
inflation forecast
2. Use nominal interest rate minus your own
inflation forecast
TIPS Bond
• The US Treasury offers bonds whose principal
and coupon payments increase with the
inflation rate.
• Investors are paid off in terms of real
purchasing power.
• Yield is equivalent to a real interest rate.
Additional Information from U.S. Treasury
Real & Nominal Interest Rates
http://research.stlouisfed.org/fred2/categories/22
π10 Year Forecast
Expected Inflation
• Surveys of professional forecasters might be
one way of getting a good predictor of
FORECAST
SURVEY



inflation. t 1
t 1
– For USA, available from Philadelphia Federal
Reserve Bank.
– For other countries, available from Consensus
Forecasts. For a price!
1 Year Inflation
10 Year Inflation
Sep-09
Sep-07
Sep-05
Sep-03
Sep-01
Sep-99
Sep-97
Sep-95
Sep-93
Sep-91
Sep-89
Sep-87
Sep-85
Sep-83
Sep-81
%
Forecasts of Future Inflation
9
8
7
6
5
4
3
2
1
0
Consensus
Forecasts
Estimated Real Rates for USA
10
•If a professional
forecast is not
available, we might
want to use today’s
inflation as a
substitute.
8
6
4
2
0
 tFORECAST
 t
1
-2
-4
-6
1975
1980
1985
1990
1995
2000
2005
Real Interest Rate - Current Inflation
Real Interest Rate - Professional Forecast Inflation
Loanable Funds Market
Loanable Funds Market
• Consider the financial market at its broadest
and most abstract.
– an amalgamation of the bond market and the
lending market (banks, etc.)
• Map the relationship between the interest rate
and the quantity of funds that are lent.
– Supply curve represents the behavior of savers &
lenders
– Demand curve represents the behavior of
borrowers
Supply Curve: Loanable Funds
• Why does the supply curve slope up?
– When real interest rates offered by banks are
high, savers are rewarded with more future
consumption and are likely to be induced to
save more.
– Caveat: If some savers are setting a target for
their level of wealth at retirement, a higher
interest rate reduces the amount they need to
save.
• For this reason, many economists believe saving
curve is very inelastic.
Demand Curve: Loanable Funds
• Why does the demand curve slope down?
– Firms borrow to finance investment projects. If the
return on investment falls below the interest rate, the
project is not worthwhile. The higher the interest rate,
the fewer projects fall below the hurdle.
– Households borrow to finance housing. The higher
are interest rates, the smaller is the house that the
householders can buy with a mortgage payment that
they can afford.
Globalization and the Loanable Funds
Market
• Even ten years ago, we might have thought of
the loanable funds market as being national in
nature – especially for large economies. These
days it appears that even the USA is part of a
single global market. [China possible
exception]
• Only very large changes in large countries or
international trends will have an impact on real
interest rates.
Competitive Market Equilibrium:
Loanable Funds Market
(Geometry)
r
DLF
SLF
r*
LF*
LF
Ex. Investment Boom in Emerging Markets
McKinsey Report
r
S
D
D'
r**
r*
2
1
LF*
LF**
LF
http://www.bea.gov/national/nipaweb/SelectTable.asp?Selected=Y
Ex. US Consumers become thriftier
r
S
D
S'
1
r*
r**
2
LF*
LF**
LF
Savings
• We divide savings into 2 parts:
SPrivate
+SPublic
= S
Private Saving
(Household + Business Saving)
Public Saving/Government Saving
(Budget Surplus)
National Saving
Public Savings is part of the supply of loanable funds if positive and part of
demand for loanable funds if negative (as usual).
Example: Government strikes a deal to
raise taxes and cut spending
r
S
D
S'
1
r**
r*
2
LF*
LF**
LF
Ex.Japanese Government runs a deficit
Budget Plan
r
S
D
2
r**
1
r*
D'
LF*
LF**
LF
National Economy
•
How do national economies relate to the
global financial market?
1. Countries will face an external interest rate,
rW, unaffected by national savings or
investment.
2. International capital flows will make up the
gap between savings and investment.
Competitive Market Equilibrium:
Loanable Funds Market
r
S
D
S+KA
r*
KA
LF*
LF
Investment Boom
[r Doesn’t Rise, Gap made up by Capital Inflows]
r
D
D'
S
1
KA
2
rW
LF*
LF**
LF
Consumers become thriftier
(r does not fall, gap made up by capital outflows)
r
D
rW
S
2
-KA
1
S'
LF
Savings Glut
• Theory put forth by Fed Chairman explaining the U.S.
trade deficit: Washington Post Article
World Interest Rate Falls
(Global Economy)
r
D
S
S+KA
rW
rW'
1
2
2
LF
Net Capital Outflows =
‘Goods & Income Outflows
•
•
•
•
Private Savings: Y + NFI -Tax – C
Public Savings: Tax – G
National Savings: S = Y+ NFI – C – G
Capital Outflows: -KA = S – I
S-I = NFI + (Y – C – G – I)= NFI +NX
http://www.bea.gov/national/nipaweb/SelectTable.asp?Selected=Y
US Current Account
1.00%
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
0.00%
-1.00%
-2.00%
-3.00%
-4.00%
-5.00%
-6.00%
-7.00%
NX
NFI
CA
Learning Outcome
• Calculate the relationship between inflation,
expected inflation, interest rates and real interest
rates.
• Use the Loanable Funds model to analyze the
effects of external events on savings, investment,
and real interest rates in capital markets.