Chapter 11

THE LEVEL AND STRUCTURE OF INTEREST RATES

Interest Rates
An interest rate is the price paid by a borrower to a lender for the use of resources that will be used during some time period then returned.
Real rate Risk-free rate Short-term rate

Theories of Interest Rates

Fishers Classical Approach

Loanable Funds Theory

Keynes Liquidity Preference Theory

Fishers Classical Approach

Supply of Savings Marginal rate of time preference- the willingness of an individual to trade some consumption now for more future consumption (e.g. Savings, 401k)

Fishers Classical Approach

Demand for Borrowed Resources
Marginal productivity of capital: The gain from additional projects, as investment increase. Firms will direct borrowed resources to projects in order of their profitability, starting with the most profitable and proceed to those with lower gains. THis is NEGATIVELY related to the amount of investment. As the amount of investment grows, additional gains necessarily fall, as more of the less profitable projects are accepted. Rate of interest- this is the rate that would prevail in the economy if the average prices for goods and services were expected to remain constant during the loans life

Fishers Law
The relationship between inflation and interest rates. Formula: (1+i) = (1+r) x (1 + p) i = nominal rate r = real rate p= expected percentage change in price level of goods and services over the loan's life. Condensed approximate formula: i = r + p

The Loanable Funds Theory

Demand for and Supply of Funds by Firms, Governments, and Households
Changes in the money supply Government deficits Changes in preferences by households New investment opportunities for firms

Equilibrium Rate of Interest

The Liquidity Preference Theory

Demand for Money Balances
Transactions demand Precautionary demand Speculative demand

Supply of Money Equilibrium Rate of Interest

Changes in the Demand for Money and Interest Rates

Liquidity Effect represents the initial reaction of the interest rate to a change in the money supply. Initial reaction should be a fall in the rate, since the money supply increased.
If increasing, causes the interest rate to rise.

Changes in the Demand for Money and Interest Rates

Income Effect In relation to the Liquidity Preference Theory. Expansion in money supply leads to more loans, leads to hired workers, leads to more hours, leads to economic expansion and thus higher income. Contraction in money supply has opposite effect with the income effect, i.e. reduces income. Over time, the income effect is likely to reverse some of the liquidity effect.
If increasing, causes the interest rate to rise.
.

Changes in the Demand for Money and Interest Rates

Price Expectations Effect If the economy is operating at less than full strength, an increase in the money supply can stimulate production, employment, output. If Economy is production all of the goods and services it can, then an increase in the MS will largely stimulate expectations of rising level of prices.
If increasing, causes the interest rate to rise.

Net Effect:
The interest rate may rise, fall, or remain unchanged depending on the net effect of changes in desired liquidity, income, and price expectations.

Features of a Bond
Time to Maturity Principal or Par Value Coupon Interest Yield-to-Maturity (YTM)??????? Maturity Value *** if there is no maturity value in that case face value will be consider as maturity value***

Features of a Bond
If YTM = coupon rate, market price = par value

Features of a Bond
If YTM > coupon rate, market price < par value

Features of a Bond
If YTM < coupon rate, market price > par value

Term to Maturity
The volatility of a bonds price is influenced by its maturity. The longer the maturity of a bond, the greater its price sensitivity to a change in market yields. Maturity spread or yield curve spread