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Chapter 11

THE LEVEL AND

STRUCTURE OFINTEREST RATES

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Interest Rates

An interest rateis the price paid by aborrower to a lender for the use of

resources that will be usedduring sometime period then returned.

Real rate

Risk-freerateShort-term rate

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Theories of Interest Rates

Fishers Classical Approach

Loanable Funds TheoryKeynes Liquidity Preference Theory

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Fishers Classical

Approach

Supply of SavingsMarginal rate of time preference- the

willingness of an individual to trade some

consumption now for more futureconsumption (e.g. Savings, 401k)

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Fishers Classical

Approach

Demand for Borrowed ResourcesMarginal productivity of capital: The gain from

additional projects, as investment increase. Firms willdirect borrowed resources to projects in order of their

profitability, starting with the most profitable andproceed to those with lower gains. THis isNEGATIVELY related to the amount of investment. Asthe amount of investment grows, additional gains

necessarily fall, as more of the less profitable projectsare accepted.

Rate of interest- this is the rate that would prevail inthe economy if the average prices for goods andservices were expected to remain constant during theloans life

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Fishers Law

The relationship between inflation andinterest rates. Formula:(1+i) = (1+r) x (1 + p)

i = nominal rater = real ratep= expected percentage change in price

level of goods and services over the loan'slife.Condensed approximate formula: i = r + p

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The Loanable Funds

Theory

Demand for and Supply of Funds byFirms, Governments, and Households

Changes in the money supplyGovernment deficits

Changes in preferences by households

New investment opportunities for firmsEquilibrium Rate of Interest

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The Liquidity Preference

Theory

Demand for Money Balances

Transactions demand

Precautionary demandSpeculative demand

Supply of Money

Equilibrium Rate of Interest

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Changes in the Demand for

Moneyand Interest Rates

Liquidity Effect

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

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Changes in the Demand for

Moneyand 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 higherincome. Contraction in money supply hasopposite effect with the income effect, i.e.

reduces income. Over time, the income effect islikely to reverse some of the liquidity effect.If increasing,causes the interest rate to rise.

.

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Changes in the Demand for

Moneyand Interest Rates

Price Expectations Effect

If the economy is operating at less than fullstrength, an increase in the money supply can

stimulate production, employment, output. IfEconomy is production all of the goods andservices it can, then an increase in the MS willlargely stimulate expectations of rising level ofprices.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 desiredliquidity, income, and price expectations.

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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 thatcase face value will be consider asmaturity value***

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If YTM = coupon rate, market price = par value

Features of a Bond

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If YTM > coupon rate, market price < par value

Features of a Bond

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If YTM < coupon rate, market price > par value

Features of a Bond

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Term to Maturity

The volatility of a bonds price isinfluenced byits maturity.

The longer the maturity of a bond, thegreater its price sensitivity toa change inmarket yields.

Maturity spread or yield curve spread