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.

The Real Rate of Interest

Is the rate of interest determined by the returns earned on
investments on productive assets.
Real rate occurs at equilibrium between desired return on
investment and time preference for consumption.
Return on investments: Producers seek financing for real
assets. The expected Return on Investments(ROI) is upper
limit on interest rate producers can pay for financing the
same investments
Time preference for consumption: People prefer to
consume goods today rather than tomorrow. This is called
positive time preference for consumption. Savers require
compensation for deferring consumption. Time value of
consumption is lower limit on interest rate at which savers
will provide financing.
Copyright 2006 John Wiley & Sons, Inc.

Determinants of the Real Rate of Interest

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Equilibrium Condition
The equilibrium rate of interest is the point where the
desired level of borrowing by DSU equals the desired level
of lending by SSUs.

The equilibrium rate of interest is also called as the real

rate of interest and determined by the real output factors in
the economy.

Copyright 2006 John Wiley & Sons, Inc.

Fluctuations in the real rate : Demand factors :

New technology spawns an increase in investment
opportunities and also increases the desired level of
borrowing.
Reduction in corporate taxes increases the amount on
investment by firms increases the borrowing and cause the
real rate of interest to increase.
Other demand factors:
Increase in the productivity of existing capital
Increase in expected business product demand
Demographic changes
The equilibrium rate of interest is also called as the real
rate of interest and determined by the real output factors in
the economy.
Copyright 2006 John Wiley & Sons, Inc.

Fluctuations in the real rate : Supply factors :

A supply factor that would shift the desired level of
lending by decreasing the real rate of interests would be
A decrease in the tax rate of the individuals.
Other factors:
Monetary policy actions
Shift in consumer attitudes about savings
Changes in economic conditions
.

Copyright 2006 John Wiley & Sons, Inc.

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.

Supply of loanable funds

All sources of funds available to invest in

financial claims:
Consumer savings
Business savings
Government budget surpluses
Central Bank Action

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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

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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.

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Loanable Funds Theory

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Loanable Funds Theory

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Loanable Funds Theory

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Loanable Funds Theory

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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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Fisher Effect
The exact Fisher equation is:

1 i 1 r 1 Pe
where
i the observed nominal rate of interest,
r the real rate of interest,
Pe the expected annual rate of inflation.

Copyright 2006 John Wiley & Sons, Inc.

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Fisher Effect, cont.

From the Fisher equation, we derive the nominal
(contract) rate:

i r Pe r * Pe

We see that a lender gets compensated for:

rental of purchasing power
anticipated loss of purchasing power on the principal
anticipated loss of purchasing power on the interest

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Fisher Effect: Example

1-year $1000 loan
Parties agree on 3% rental rate for money and
5% expected rate of inflation.
Items to pay
Calculation
Amount
Principal
$1,000.00
Rent on money
$1,000 x 3%
30.00
PP loss on principal $1,000 x 5%
50.00
PP loss on interest $1,000 x 3% x 5%
1.50
Total Compensation
$1,081.50

Copyright 2006 John Wiley & Sons, Inc.

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Simplified Fisher Equation

The third term in the Fisher equation is

negligible, so it is commonly dropped. The
resulting equation is

i r Pe

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Expectations ex ante v. Experience ex post

Realized rates of return reflect impact of

inflation on past investments.
r = i - Pa, where the "realized" rate of return
from past transactions, r, equals the nominal rate
minus the actual annual rate of inflation.
As inflation increases, expected inflation
premiums, Pe, may lag actual rates of inflation, Pa,
yielding low or even negative actual returns.
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Impact of Inflation under Loanable Funds Theory

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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.

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