Chapter 2
Money, Credit, and the
Determination of Interest
Rates
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Chapter 2 Learning Objectives
 Understand how the supply and demand for money
and credit affect (and are affected by) the economy
and the general level of interest rates
 Understand how yields on individual debt instruments
are determined
 Understand why securities of different maturities may
have different yields
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The General Level of Interest Rates
 Assume that only one type of credit instrument exists (e.g. a bond)
 The bond is riskless
 No inflation expectation
 The price of the bond is inversely related to and determined by the market-required yield
 Market value of the bonds can be defined in terms of either their price or their yield.
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The General Level of Interest Rates
 Interest rate on an instrument reflects general market
rates and the risk of the specific instrument
 Transition mechanism of money and interest rates:
 Money supply → economy → inflation → inflationary
expectations → credit markets → interest rates
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The General Level of Interest Rates
 Equation of Exchange MV = PT


M = money supply
V = velocity of circulation (the average number of time$1
turns over in 1 year)

P = general price level

T = the volume of trade
 Monetary theory of inflation
 The greater the rate of growth in money, the grater the rate
of inflation
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The Fisher Equation
 The inflation rate plays an important role in the
determination of market rates
 Fisher equation: I = r + p
 I – the equilibrium nominal rate of interest observed in the
credit market
 r – the real interest rate
 P – the expected inflation over the maturity of the
instrument
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The Relationship between Inflation and TBill Yield
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The Gibson Paradox
 An increase in money supply leads to increases in
demand for bonds and goods and services, resulting in
upward pressure on bond prices, forcing interest rates
down.
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Liquidity, Income and Price-Anticipation
Effects
 Liquidity effect (short-run)
 Money supply goes up
 Demand for bonds goes up
 Interest rates go down
 Income effect
 Income goes up
 Demand for credit goes up
 Interest rates go up
 Price anticipation effect
 Future expected inflation
 Decrease in supply of credit
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Liquidity, Income and Price-Anticipation
Effects
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Risks In Real Estate Finance
 Default risk
 Risk that the borrower will not repay the mortgage per the
contract
 Callability risk
 Borrower may repay the debt before maturity
 Maturity risk
 Other things held constant, the longer the maturity the
greater the change in value for a given change in interest
rates
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Risks In Real Estate Finance
 Marketability risk
 Risk that the asset doesn’t trade in a large, organized market
 I = r + p + k, where k is risk premium associated with
noninflationary risks
 Inflation risk
 Risk in loss of purchasing power
 Interest rate risk
 Risk of loss due to changes in market interest rates
 Fixed-income assets are most susceptible
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Description of Agency Ratings
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Income Tax Considerations
 Municipal bonds – issued by government jurisdictions
other than the federal government
 Interest from municipal bonds is tax free
 The tax-free nature of these instruments implies that
investors will receive lower return on these bonds
 MY = TY(1 – T)
where MY is the yield on a municipal bond, TY is the taxable
yield on a comparable non-municipal bond, T is the investor’s
tax rate.
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The Yield Curve
 Relates maturity and yield at the same point in time
 Theories explaining the structure of the yield curve:
 Liquidity Premium Theory
Long-term rates tend to be higher that short-term rates
 Market Segmentation Theory
There are two (or more) markets for securities of different maturities
Assumes that investors will not change their preferences as a result of yield
discrepancies
 Expectations Theory
The long-term rate for some period is the average of the short-term rates over that
period
Upward-sloping (downward-sloping) curves indicate that market participants
expect rates to rise (fall) in the future.
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Yield Curve
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Explaining the Yield Curve
 Liquidity premium
 Premium paid for liquidity
 Segmented markets
 Market divided into distinct segments
 Expectations theory
 Current rates are the average of expected future rates
 The current two-year rate is the average of the current oneyear rate and the one-year rate a year from now
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Examples of Yield Curves
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