CHAPTER 4

THE LEVEL OF
INTEREST RATES

Learning Objectives

1. Define the concept of an interest rate and explain the

role of interest rates in the economy.
2. Define the concept of the real interest rate and explain
what causes the real interest rate to rise and fall.
3. Explain how inflation affects interest rates.
4. Calculate the realized real rate of return on an
investment.
5. Explain how economists and financial decision makers
forecast interest rates.

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 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.

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 Determinants of the Real Rate of Interest

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

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 Supply of loanable funds—

All sources of funds available to invest in

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

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.

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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.

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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. 17

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.

Copyright© 2006 John Wiley & Sons, Inc. 19

Inflation and Interest Rates

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 Impact of Inflation under Loanable Funds Theory

If expected inflation increases, prospective lenders should have a tendency to

increase their current consumption, thus reducing the available funds: the supply
schedule shifts upwards.
In contrast, prospective borrowers should have a tendency to increase their future
consumption, thus increasing the needed funds: the demand schedule shifts upwards as
well.
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The nominal interest rate will move up.

Movements of Interest Rates 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. 22

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 NEGATIVE INTEREST RATES

The real rate of interest is always positive because the

human nature is such that nearly all market participants
have a positive time preference for consumption.
In a classical economic system, interest rates are determined by the return on real
assets and by society’s positive time preference. Because the economic
system is in real terms, the real rate of interest is always positive.
The Fisher equation suggests that a negative nominal
interest rate occurs when the expected rate of deflation
(a negative term) exceeds the real rate of interest.
In a monetary system where inflation/deflation can occur, the nominal interest
rate can mathematically be negative when the deflation rate is larger than the
real interest rate.
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NEGATIVE INTEREST RATES

Negative interest rates occur infrequently and usually
only when a country's central bankers are forced to
utilize the monetary policy tool -- where the interest
rates are set below zero -- during harsh economic times.
A negative interest rate means the lender is paying the
individual or business to borrow money from them,
which means that borrowers get paid and savers are
penalized.
In harsh economic times, people and businesses tend to
hold on to their cash while they wait for the economy to
improve. This strategy stimulates borrowing and
lending.
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 FORECASTING INTEREST RATES
There are two of the popular forecasting methods used by
economists on Wall Street: statistical models of the
economy and the flow-of-funds approach.

ECONOMIC MODELS
FLOW-OF-FUNDS ACCOUNT FORECASTING

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ECONOMIC MODELS
Economic models predict interest rates by estimating the statistical
relationships between measures of the output of goods and services in the
economy and the level of interest rates.
The common element of all such models is that they produce interest rate
forecasts assuming that the pattern of causality among economic variables
is stable into the future.
A more modest model is one developed by the Federal Reserve Bank of St.
Louis.
This model consists of only eight basic equations and generates quarterly
forecasts for a number of key economic variables, such as the change in
nominal and real GDP, the change in the price level (inflation), the
unemployment rate, and the market rate of interest.
The key input variables into the model are the
change in the nation’s money supply, the change in federal government
expenditures, the potential full-
full-employment output of goods and services in
the economy, and past changes in price levels.
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FLOW-OF-FUNDS ACCOUNT FORECASTING

One of the most widely used interest rate forecasting

techniques uses the flow-of-funds framework embedded
within the loanable funds' theory of interest rates.
The flow-of-funds data show the movement of savings―the
sources and uses of funds―through the economy in a
structured and comprehensive manner.
The flow-of-funds accounts are companion data to the
national income accounts, which provide information about
the flow of goods and services in the real economy.
Most of these studies conclude that interest rate forecasters
perform poorly.

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