Вы находитесь на странице: 1из 23

# Power Point Slides for:

## Financial Institutions, Markets, and

Money, 9th Edition
Authors: Kidwell, Blackwell, Whidbee &
Peterson
Prepared by: Babu G. Baradwaj, Towson University
And
Lanny R. Martindale, Texas A&M University

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.

## The Real Rate of Interest

Producers seek financing for real assets. Expected
ROI is upper limit on interest rate producers can
pay for financing.
Savers require compensation for deferring
consumption. Time value of consumption is lower
limit on interest rate at which savers will provide
financing.
Real rate occurs at equilibrium between desired
real investment and desired saving.

## 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

## All sources of funds available to invest in

financial claims:
Consumer savings
Government budget surpluses
Central Bank Action

## Demand for Loanable Funds

All uses of funds raised from issuing
financial claims:
Consumer credit purchases
Government budget deficits

## 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.

## Price Expectations and Interest Rates

Unanticipated inflation benefits borrowers at
expense of lenders.
Lenders charge added interest to offset anticipated
Expected inflation is embodied in nominal interest
rates: The Fisher Effect.

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.

## 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:

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

## 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

## The third term in the Fisher equation is

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

i r Pe

## 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.