CHAPTER 4
INTEREST RATES
What are Interest Rates?
Cost of borrowing or the return on lending
Price of money
The time value of money
Opportunity cost of current consumption
As with any price, interest rates serve to
allocate funds among alternative uses.
Copyright© 2003 John Wiley and Sons, Inc.
What Determine Interest Rates?
Loanable Funds Theory
Interest rates are determined in the debt markets by the
supply of loanable funds (lending) and demand for
loanable funds (borrowing).
The quantity supplied is positively related to interest
rates, and the quantity demanded is negatively related
to interest rates.
Increase in the supply of loanable funds (shift to the
right) causes interest rates to decline.
Increase in the demand for loanable funds (shift to the
right) causes interest rates to rise.
Copyright© 2003 John Wiley and Sons, Inc.
Loanable Funds Theory
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Supply and Demand Sources
Households, business firms, government, and foreigners are both suppliers and
demanders of loanable funds. During most periods, households are net
suppliers of funds, whereas the government is almost always a net demander
of funds.
Supply of Loanable Funds (SSU)
Consumer savings
Business savings (depreciation and retained earnings)
Government budget surplus (if any)
Foreign Savings
Demand for Loanable Funds (DSU)
Consumer purchases
Business investment (fixed and inventory investments)
Government budget deficit
Foreign Borrowing
Copyright© 2003 John Wiley and Sons, Inc.
Change in the Supply of Funds
(Lending)
Preference for Consumption overtime:
Preference for Future Consumption↑
(People become more Patient) → Savings↑
→ S↑ (Shifts Right) → i↓
Business Cycle Expansion↑ → Income↑ →
Savings↑ → S↑ (Shifts Right) → i↓
Expected Inflation → S↓ (Shifts Left) → i↑
Copyright© 2003 John Wiley and Sons, Inc.
Change in the Demand for Funds
(Borrowing)
Preference for Consumption overtime:
Preference for Future Consumption↑ (People
become more Patient) → Borrowing↓ → D↓
(Shifts Left) → i↓
Business Cycle Expansion↑ → Availability of
Good Investments↑ → D↑ (Shifts Right) → i↑
Government Budget Deficit↑ → Government
Borrowing↑ → D↑ (Shifts Right) → i↑
Expected Inflation↑ → D↑ (Shifts Right) → i↑
Copyright© 2003 John Wiley and Sons, Inc.
Expected Inflation and Interest
Rates
Expected inflation is embodied in nominal interest rates The Fisher Effect
When inflation is expected to increase, lenders want
compensation for expected decline in the purchasing
power of their loans → S↓ (Shifts Left) → i↑
When inflation is expected to increase, borrowers
expect to pay less in terms of goods and services on
their loans → D↑ (Shifts Right) → i↑
Copyright© 2003 John Wiley and Sons, Inc.
Expected inflation and Interest
Rates
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Interest Rate Changes and
Changes in Inflation
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The Fisher Effect
The Fisher equation is
(1 + i) = (1 + r) (1 + πe)
where
i = the nominal interest rate (in terms of
money)
r = the real interest rate (in terms of goods
and services)
πe = the expected inflation rate
Copyright© 2003 John Wiley and Sons, Inc.
The Fisher Effect
From the Fisher equation, with a little algebra, we
see that the nominal interest rate is
i = r + πe + (r * πe )
The lender gets compensated for:
rent on money = r.
compensation for loss of purchasing power on the
principal = πe.
compensation for loss of purchasing power on the
interest = r * πe.
Copyright© 2003 John Wiley and Sons, Inc.
Fisher Effect
Example: 1-year $1,000 loan at 3% real interest
rate and a 5% expected inflation rate.
Items to Pay
Principal
Rent on Money
Purchasing Power
Loss on Principal
Purchasing Power
Loss on Interest
Total Compensation
Calculation
$1,000 * 3%
$1,000 * 5%
$1,000 * 3% * 5%
Amount
$1,000.00
30.00
50.00
1.50
$1,081.50
Copyright© 2003 John Wiley and Sons, Inc.
The Fisher Effect
When expected inflation is low, (r * πe) is
approximately equal to zero, so it is
dropped in many applications. The
resulting equation is referred to as the
approximate Fisher equation:
i ≈ r + πe
Copyright© 2003 John Wiley and Sons, Inc.
The Fisher Effect
The actual real interest rate reflect the
impact of inflation.
r ≈ i - π, where the actual real interest rate, r,
equals the nominal interest rate minus the
actual inflation rate.
With increasing inflation rates, inflation
premiums, πe, may less than actual inflation
rates, π, yielding low or even negative actual
real interest rates.
Copyright© 2003 John Wiley and Sons, Inc.
Summary
Real interest rate compensates for delayed
consumption. The higher the desire for current
consumption, the higher the real interest rate.
The real interest rate is the long-term base of nominal
interest rate. It is determined by real factors in the
economy such as preferences for consumption over
time, economic growth and government budget deficit.
The nominal interest rate is determined by the real
interest rate and expected inflation as shown by the
Fisher equation.
Copyright© 2003 John Wiley and Sons, Inc.