Overview of Interest Rate

By: Hyder Ali Khawaja
Interest Overview
Interest
Price paid to borrow money Interest is the charge made for borrowing a sum of money. It is cost of capital or cost of utilization of money. It is difference between amount returned and amount borrowed.
Example: If you borrow Rs.1000 and return Rs.1200, 200 that you are supposed to pay in excess of borrowed amount is interest.
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Interest Overview (Cont..)

Interest rate Interest rate is charge made expressed as a percentage of amount lent. Example: If you borrow Rs.500 at 10% 10% is interest rate
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The Allocative Role of Interest

Allocate Role
It means to give something to someone to use in a particular way.
Allocate Role of Interest

Allocation of money (credit or loanable funds) is defined by interest.
For example
One million is available as credit at 15% Business A Business B Expected return 12% (Reject) Expected return 20% (Accept)
Simply one will get the loan that is willing to pay highest rate of interest. (In case of scarcity)
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Determination of the Market Rate of Interest

The Supply of Credit
The Demand for Credit
Determination of the Market Rate of Interest (Cont..)

The Supply of Credit
Supply of credit refers to savings made by net savers; net savers are those who have amounts in excess of their expenditure. Income= Consumption + Savings Income=2000 Consumption=1500 Savings=500
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Who are the Supplier of Credit?
Net Savers Households Businesses Government

When will net savers save??
When interest rates are high net savers are motivated to save for rainy days and for higher returns.
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The Demand for Credit
Demand for credit refers to amount of money borrowed by net borrowers
Who demand credit?

Households, Businesses & Government
Example
If you have business you have an opportunity to invest Rs 100 in new machinery having life of 1 year which will increase your cash inflows by 110. Your return will be Rs 10 Return=Inflow-outflow Return=110-100 Return=10
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The Demand for Credit (Cont..)
Example (Cont..)
Rate of return will be 10% Rate of return=Inflow-outflow/outflow Rate of return=110-100/100 or 10/100=0.1 or 10% If that 100 is available at 8% interest rate, should you take it or not? In this condition you will demand 100 as credit because it is profitable for you because on 100 you have to pay 8% interest and your rate of return is 10%, it means even after payment of interest you are still earning 2% profit.
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Example (Cont..) But if you were asked to pay interest rate of 12% then you must have rejected that credit. So when a business feels that there is any profitable opportunity it will demand credit.
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When interest rates are high businesses are discouraged to take credit and when interest rates are low businesses are motivated to take more credit.
Example
Return from investment 15% When interest rate is 12% Return after paying interest= 15%-12%=3% But if interest rate is 16% Return after paying interest= 15%-16%= -1% Means loss of 1%
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The Market Rate of Interest

The Market Rate of Interest
It is determined by demand and supply for credit. Interest rate at which demand and supply are equal is known as market rate and that point is known as equilibrium point.
It changes with change in demand and supply of credit
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Equilibrium Interest Rate

The Interaction of Money Supply and Demand
Equilibrium
The condition for equilibrium is: Ms = Md The equilibrium condition can be expressed in terms of aggregate real money demand as: Ms/P = L(R,Y)
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Equilibrium Interest Rate (Cont..)

Determination of the Equilibrium Interest Rate
Interest rate, R
Real money supply

2
R2
R1 R3
1 3
Aggregate real money demand, L(R,Y)
Q2
MS ( = Q 1 ) P
Q3
Real money holdings

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Interest Rates and the Money Supply
An increase (fall) in the money supply lowers (raises) the interest rate, given the price level and output. The effect of increasing the money supply at a given price level is illustrated in Figure
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Effect of an Increase in the Money Supply on the Interest Rate
Interest rate, R
An increase in the money supply lowers the interest rate for a given price level.
Real money supply
Real money supply increase
R1 R2
1 2
A decrease in the money supply raises the interest rate for a given price level.
L(R,Y1)
M1 P
M2 P
Real money holdings
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Output and the Interest Rate
An increase (fall) in real output raises (lowers) the interest rate, given the price level and the money supply. Figure shows the effect on the interest rate of a rise in the level of output, given the money supply and the price level.
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Effect on the Interest Rate of a Rise in Real Income
Interest rate, R Real money supply Increase in real income R2 R1 2
An increase in national income increases equilibrium interest rates for a given price level.
1' L(R,Y2)
L(R,Y1)
MS ( = Q 1 ) P Q2 Real money holdings
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Example Suppose money supply and demand functions are given which depend upon the rate of interest (I) Ms (I)= 5 + 3I Md (I) = 45 5I Find the equilibrium interest rate and quantity of money supplied and demanded.
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Solution As we know equilibrium is point where Ms = Md So put the values of Ms and Md 5 + 3I = 45 5I 3I + 5I = 45 5 8I = 40 I = 40/8 I=5 It means equilibrium point (market rate) is 5% interest rate
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Solution (Cont..) To find the amount of money demanded & supplied, put value of I in respective equations Ms (I)= 5 + 3I Ms (I)= 5 + 3(5) = 20 millions Md (I) = 45 5I Md (I) = 45 5(5) = 20 millions
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Interest Rate Money Demanded Md (I) = 45 5I (In million rupees) Money Supplied Ms (I)= 5 + 3I (In million rupees)
2% 3%
35 30
11 14
4% 5% 6% 7% 8%
25 20 15 10 5
17 20 23 26 29
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Interest Rate
2% 3%
4% 5% 6% 7% 8%
Note: 35 At 30 5% Money demanded 25 Is equal 20 to 15 Money supplied

10 5
Money Demanded Md (I) = 45 5I (In million rupees)
Money Supplied Ms (I)= 5 + 3I (In million rupees)
11 14
17 20 23 26 29
25
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Money Market
Money market
Where monetary or liquid assets, which are loosely called money, are lent and borrowed.
Monetary assets in the money market generally have low interest rates compared to interest rates on bonds, loans, and deposits of currency in the foreign exchange markets.
Domestic interest rates directly affect rates of return on domestic currency deposits in the foreign exchange markets.
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Money Market (Cont..)

Rate of interest, i (percent)
Sm
10 7.5 5 2.5 0 Suppose the money supply is decreased from Rs200 billion, Sm, to Rs150 billion Sm1.
ie
Dm
0 50 100 150 200 250 300
Amount of money demanded (billions of rupees)

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Sm1
10 7.5 5 2.5 0
Sm
A temporary shortage of money will require the sale of some assets to meet the need.
ie
Dm
0 50 100 150 200 250 300

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Sm
10 7.5 5 2.5 0 Suppose the money supply is increased from Rs200 billion, Sm, to Rs250 billion Sm2.
ie
Dm
0 50 100 150 200 250 300

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Sm Sm2
10 7.5 5 2.5 0
ie
A temporary surplus of money will require the purchase of some assets to meet the desired level of liquidity.
Dm
0 50 100 150 200 250 300

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Equilibrium
When no shortages (excess demand) or surpluses (excess supply) of monetary assets exist, the model achieves an equilibrium: Ms = Md Alternatively, when the quantity of real monetary assets supplied matches the quantity of real monetary assets demanded, the model achieves an equilibrium: Ms/P = L(R,Y)
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Excess Supply of Monetary Assets
When there is an excess supply of monetary assets, there is an excess demand for interest bearing assets like bonds, loans, and deposits. People with an excess supply of monetary assets are willing to offer or accept interest-bearing assets (by giving up their money) at lower interest rates. Others are more willing to hold additional monetary assets as interest rates (the opportunity cost of holding monetary assets) falls.
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Excess demand of monetary assets
When there is an excess demand of monetary assets, there is an excess supply of interest bearing assets like bonds, loans, and deposits. People who desire monetary assets but do not have access to them are willing to sell non-monetary assets in return for the monetary assets that they desire. Those with monetary assets are more willing to give them up in return for interest-bearing assets as interest rates (the opportunity cost of holding money) rises.
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Nominal versus Real Interest Rate

Nominal Interest Rate A rate at which your amount is growing Example: 10% annually
Real Interest Rate

Real rate is adjusted for inflation and is a rate at which purchasing power of invested money is increasing.
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Real Interest Rate (Cont..) It is calculated with following formula Real Rate of Interest = Nominal rate Inflation rate (CPI) or Real Rate of Interest = [(1+Nominal)/(1+Inflation)] 1 Nominal Rate = real rate + expected inflation + (real rate x inflation)
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Example
You are offered by a bank to save your 1000 at 10% interest rate for one year. Here 10% is nominal interest rate, but consider that after 1 year price of goods will increase by 6%. What is real rate of interest?
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Example (Cont..)
Nominal Rate = 10% Inflation (CPI) = 6% Real Rate = ?

Real Rate of Interest = [(1+Nominal)/(1+Inflation)] - 1
Real Rate = [1.1/1.06] 1

Real Rate = 3.77%
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Example In zero inflation world, if wheat costs Rs. 1 per Kg and you lend Rs. 10, youre lending 10 kg wheat. If you want a real return of 10%, you need 11 Kg wheat (1/10=10%) so you charge 10% interest and get Rs. 11 back If inflation is 20%, (mean 1 Kg will cost 1.2) then you need Rs. 1.20 x 11 = Rs. 13.20 back to buy 11 Kg and get your 10% real return. This means you must charge a nominal rate of 32%
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Example (Cont..)
Real Rate = 10% Inflation = 20% Nominal Rate = ? Nominal Rate = real rate + expected inflation + (real rate x inflation) Nominal Rate = 0.1 + 0.2 + (0.1 x 0.2) Nominal Rate = 0.3 + 0.02 Nominal Rate = 0.32 Nominal Rate = 32 %
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Ex Ante. Vs. Ex Post

Ex Ante real interest rate Ex Ante real interest rates are the rates investors expect based on anticipated inflation rates Ex Post real interest rate Ex Post real interest rates are the rates investors actually receive after the fact.
The difference between the two depends on the
accuracy of inflationary expectations

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Inflation Expectations and Real Returns

Inflation expectation tend to be quite persistent (i.e.
investors dont seem to update to new information). Therefore, real interest rates also have a high degree of persistence.
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Types of Nominal Interest Rates

The Prime Rate
The Corporate Bond Rate
The Federal Funds Rate Discount rate
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Types of Nominal Interest Rates (Cont..)

The Prime Rate
Interest rate charged by banks to their most creditworthy customers on short term loans. Same as Products are sold at lower profit margin to loyal customers (Lower Price)
For example
Normal nominal interest rate charged by banks is 10%, but bank may advance short term loan to its most creditworthy customer below 10%.
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Types of Nominal Interest Rates

The Prime Rate (Cont..)
Determinants of Customer Creditworthiness

Profitability of business
Turnover
How frequently cash is coming in and going out from account (inflows and outflows or deposit and withdrawals).
Risk
Less risky companies have strong capacity to pay their debts.
Relationship between customer and bank Rating of business in terms of default risk
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The Corporate Bond Rate
Interest Rate on corporate bonds This rate is known as the coupon rate because most bonds used to have coupons that the investors clipped off and mailed to the bond issuer to claim the interest payment.
These bonds are issued by highly rated companies having low risk of default.
Standard and Poors (S&P) and Moodys provide risk ratings of corporate and government bonds.
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Corporate Bond Rate (Cont..)
According to Moodys Aaa (best quality) Baa (lower medium quality) Caa (poor standing) C (extremely poor)
According to S&P AAA (best quality)
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Bond Rating Criteria
Various ratios
Including the debt ratio and the times-interest-earned ratio. The better the ratios, the higher the rating.
Mortgage provisions
Is the bond secured by a mortgage? If it is, and if the property has a high value in relation to the amount of bonded debt, the bonds rating is enhanced.
Guarantee provisions
Some bonds are guaranteed by other firms. If a weak companys debt is guaranteed by a strong company (usually the weak companys parent), the bond will be given the strong companys rating.
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Sinking fund
Does the bond have a sinking fund to ensure systematic repayment? This feature is a plus factor to the rating agencies.
Maturity
A bond with a shorter maturity will be judged less risky than a longer-term bond, and this will be reflected in the ratings.
Stability
Are the issuers sales and earnings stable?
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Regulation
Is the issuer regulated, and could an adverse regulatory climate cause the companys economic position to decline? Regulation is especially important for utilities and telephone companies.
Antitrust
Are any antitrust actions pending against the firm that could wear down its position?
Overseas operations
What percentage of the firms sales, assets, and profits are from overseas operations, and what is the political climate in the host countries?
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Environmental factors
Is the firm likely to face heavy expenditures for pollution control equipment?
Product liability
Are the firms products safe? This refers to public trust; companies with low public trust possess low bond ratings.
Labor unrest
Are there potential labor problems on the horizon that could weaken the firms position?
Accounting policies
If a firm uses relatively conservative accounting policies, its reported earnings will be of higher quality than if it uses less conservative procedures. Thus, conservative accounting policies are a plus factor in bond ratings.
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Federal Fund rate (iff )
Rate at which banks lend money to other banks Interbank overnight rate
Discount Rate (id)

Rate at which central bank lends to commercial banks
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The Calculation of Interest Yields

Nominal Yield
Current Yield
Yield to Maturity (YTM)
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Calculation of Interest Yields (Cont..)

Nominal Yield
Yield is interest on bond also called coupon amount. Nominal yield is return on face value or par value. If bond offers 100 coupon amount on 1000 face value, nominal yield will be coupon amount divided by face value
Nominal yield = I/Face value

I = coupon amount = 100 Face value = 1000 Nominal yield = 100/1000 = 10%
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Calculation of Interest Yields (Cont..)

Current Yield Yield as percentage of current market price rather than face value Take above example that if same bond is sold at 850 (Discount) current yield will be calculated as under
Current yield = I/Market value Current yield = 100 / 850 = 11.76%

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The Calculation of Interest Yields

Yield to Maturity (YTM)
Also known as internal rate of return of bond, it tells how much return you will get till the maturity of bond YTM is that discount rate that equates the present value of bonds cash flows to the market price. YTM cannot be calculated without market price
Approximation Formula
YTM = I + (V-P)/T (V+P)/2
I = Coupon Amount (Par Value x Coupon rate) V = Par Value P = Price of Bond T = Periods remaining to maturity
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Interest Rate Changes and Bond Price Changes

Relationship between bond Price & Interest rate
There is inverse relationship between bond prices and interest rates If interest rate increases, bond prices decreases.
Example
A bond with 1000 face value 10 years remaining to maturity offering 10% coupon rate is currently trading at 1000. Market interest rate is 10%.
According to rule:
When coupon rate = market rate . Bond will be sold at par When coupon rate > market rate .. Bond will be sold at premium When coupon rate < market rate . Bond will be sold at discount
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Example (Cont..)
Now consider that interest rate in the market increases from 10% to 12% 15% 20%
Market Rate 10% 12% 15% 20%
Maturity 10 10 10 10
Coupon Rate 10% 10% 10% 10%
Price 1000 886.97 748.98 580.7

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Rupees 1000 900 800 700 600 500 400 300 200 100 0
Price
10%
12%
15%
20%
Interest Rate
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Rupees 1200
1000 800 600 400 200

0 10% 12% 15% 20% Interest Rate Price
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Why different bonds have different prices and different interest rates?
Bonds possess various features and their prices and
interest rates are affected by those features.

There are major four features
Default or credit risk Liquidity Tax Treatment Maturity
According to these features we can categorize the causes of
different interest rates for different bonds into;

Risk Structure of Interest rates Term Structure of Interest Rates
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Accounting for Different Interest Rates

Risk Structure of Interest rates
Differential Default Risk Differential Liquidity Differential Tax Treatment
Term Structure of Interest Rates

Segmented Markets Hypothesis Pure Expectations Hypothesis Maturity Preference Theory
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Risk Structure of Interest Rate

Risk structure of interest rate refers to the bonds/debt
with same maturity but different characteristics These bonds have different level of
Default risk Liquidity risk Tax treatment
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Risk Structure of Interest Rate (Cont..)

Differential Default Risk
Risk of not receiving timely payment of principal and/or interest Depends on creditworthiness of issuer Why Government T-bills have low interest rate than corporate bonds? Simply because Government has zero default risk and private companies may fail to pay interest or principal amount (face value).
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Differential Default Risk (Cont..)
Why T-bills have zero default risk? Because T-bills are backed by full faith and credit of government and government has Power to tax largest economy Power to issue stable currency
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Differential Default Risk (Cont..) When there is higher default risk, interest rates will also be higher to compensate for that risk. Infact investors are risk averse when default risk increases, company rating falls and investors require higher yield. Example
MCB and HBL issue bonds in market paying 10% coupon with 10 years maturity. Suppose both have same credit ratings AAA. After one year HBLs rating falls from AAA to BBB. This means default risk increases.
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Example (Cont..)
As a result of this;
HBL
Rating falls Risk will increase
MCB
Rating remains same Risk remains same
Demand for bonds will decrease

Price will fall (from 1000 to 950) YTM will rise (from 10 to 11%)
Demand for bonds will increase

Price will rise (from 1000 to 1050) YTM will fall (from 10 to 9%)
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Example (Cont..)
The difference between two interest rates is called spread, it is measured in percentage points basis points 1 percentage point = 100 basis points So in MCB and HBL example difference between two rates means 11% and 9% is known as spread which is default risk premium.
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Other Examples 3 month T-bill 2.75% 3 month Commercial paper 3.25% Spread (3.25 2.75) 0.5 percentage points 50 basis points 10 year T-note 10 year BBB corporate bond spread 2.8 percentage points 280 basis points 3.74% 6.54%
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Example (Cont..)
Taking same example of HBL & MCB calculate the current yield of both bonds
HBL
Current yield = Coupon amount / Current price Current yield = 100/950 Current yield = 10.52%
MCB
Current yield = Coupon amount / Current price Current yield = 100/1050 Current yield = 9.52%
Additional yield is premium for default risk

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Differential Liquidity Liquidity refers to ability to be converted into cash. Liquid bonds are those having secondary market, where investors can resell to get their money back. For example MCB and SisTech issues bonds which one you will prefer?? Definatly MCB because it has secondary market you can sell your bond whenever you want.
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Differential Liquidity (Cont..)
Example
Now take an example of MCB and HBL If HBL bonds have low liquidity as compared to bonds of MCB
HBL
Demand for bonds will decrease Price will fall YTM will rise
MCB
Demand for bonds will increase Price will rise YTM will fall
Note: More liquid companies pay low interest rates whereas less
liquid companies pay higher rates of interest.
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Differential Tax Treatment As tax is a burden for everyone. Some bonds are tax exempted and some are taxable. Tax exempt bonds give less interest rate (yield) whereas taxable bonds pay high yield. Why? Because tax exempt provide tax benefit
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Differential Tax Treatment (Cont..)
Example
Take two bonds
Tax Exempt Bond

Face Value = 1000 Coupon rate = 10% Coupon Amount = 100 Tax Rate = 30% Net Earning = 100 (No tax paid)
Taxable Bond
Face Value = 1000 Coupon rate = 10% Coupon Amount = 100 Tax Rate = 30% Net Earning = 100 taxes Net Earning = 100 (30% of 100) Net Earning = 100 30 Net Earning = 70
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We can calculate the after tax yield with the help of following formula After tax yield = nominal yield (1 - T) When tax rate is 30% & nominal yield is 10%
After tax yield = 0.1 (1-0.3) After tax yield = 0.07 or 7% This is the reason that taxable bonds have higher rate of yield to cover tax advantage of tax exempt bond.
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Example # 2
Personal income tax rates are given below 0-1000 15% 1001-2000 20% 2001-3000 30%
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Person A with Tax Exempt Bond Income = Rs. 2000 Bonds 10 (10% coupon rate) Total Interest earned on 100 on each (100x10 = 1000) Total Earning = 2000 + 1000 = 3000 Taxable Income = 2000 Taxes Payable 1000 x 0.15 = 150 1000 x 0.2 = 200 Person B with Taxable Bond Income = Rs. 2000 Bonds 10 (10% coupon rate) Total Interest earned on 100 on each (100x10 = 1000) Total Earning = 2000 + 1000 = 3000 Taxable Income = 3000 Taxes Payable 1000 x 0.15 = 150 1000 x 0.2 = 200 1000 x 0.3 = 300 Total Taxes = 650 Income after Taxes = 3000 650 = 2350
Total Taxes = 350 Income after Taxes = 3000 350 = 2650
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Person A with Tax Exempt Bond Income = Rs. 2000 Bonds 10 (10% coupon rate) Total Interest earned on 100 on each (100x10 = 1000) Person B with Taxable Bond Income = Rs. 2000 Bonds 10 (10% coupon rate)
Total Interest earned on 100 on each Key point: (100x10 = 1000) Person B has paid Total Earning = 2000 + 1000 = 3000 Total Earning = 2000 + 1000 = 3000 Taxable Incomemarginal = 2000 Taxable Income = 3000 tax rate of 30% on income Taxes Payable Taxes Payable 1000 x 0.15 = 150 1000 x 0.15 = 150 earned from bonds 1000 x 0.2 = 200 1000 x 0.2 = 200
1000 x 0.3 = 300

Total Taxes = 350 Income after Taxes = 3000 350 = 2650 Total Taxes = 650 Income after Taxes = 3000 650 = 2350
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Term Structure of Interest Rates

Bonds with the same characteristics, but different
maturities
Yield Curve Slope of curve indicates relationship between maturity and yield Normally as maturity increases yield decreases, as there are some risks involved, so to compensate those risks, investors require more return.
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Term Structure of Interest Rates (Cont..)

Yield Curve (Cont..)
Facts about the yield curve Interest rates on bonds of different maturities generally move together ST bond yields are more volatile than LT bond yields The yield curve usually slopes up.
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Example There are 10 different bonds all offer 10% coupon and have current price of Rs 900 and a par value Rs 1000. But maturity is different for each bond.
Maturity
1 2 3 4 5 6 7 8 9 10
YTM (%)
21.05 15.79 14.03 13.15 12.63 12.28 12.03 11.84 11.69 11.57
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YTM 25
20
15 10
5
0 1 2 3 4 5 6 7 8 9 10 Maturity
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Traditional Theories of the Term Structure

Market Segmentation Theory
Pure Expectations Theory
Maturity Preference Theory
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Traditional Theories of the Term Structure (Cont..)

Market Segmentation Theory Debt markets are segmented by maturity, Distinct markets for short term, intermediate and long term bonds (segmentation) So interest rates for various maturities are determined separately in each segment.
Therefore yield curve can take any shape

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Pure Expectations Theory
This hypothesis assumes that buyer and seller find bonds of different maturities to be perfect substitutes Investor invests in bonds with different maturities when he expects same return on all bonds.
Example A 5 rupees pen can last for 5 days, you will purchase a 10 rupee pen when you will expect that 10 rupee pen will last for 10 days.. equal return.
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Pure Expectations Theory (Cont..)
Example:
Take two bonds
Bond A
Maturity 2 years Coupon 10% Total return = 200
Bond B
Maturity 1 year Coupon 8 % If you choose Bond B than calculate the reinvestment rate Return in 1st year = 80 You require 120 in 2nd year Means you expect 12% rate in next year
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Pure Expectations Theory (Cont..)
Formula Fi = 2i2 i1
Fi= Implied future short term rate i2 = Annualized yield on the 2 year bond i1 = Annualized yield on the 1 year bond Fi = 2i2 - i1 Fi = 2(0.1) 0.08 Fi = 0.2 0.08 Fi = 0.12 or 12 %
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Maturity Preference Theory
Long-term interest rates contain a maturity premium (term premium) necessary to induce lenders into making longer term loans.
The Term Premium

Term premium is the premium for holding security for long term. Bonds with different maturities have different term premiums During Economic expansion (Low term premium) During Economic contraction (High term premium)
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Modern Term Structure Theories

Theory # 1
Long-term bond prices are much more sensitive to interest rate changes than short-term bonds. This is called interest rate risk.
So, the modern view of the term structure suggests that: NI = RI + IP + RP

In this equation: NI = Nominal interest rate RI = Real interest rate IP = Inflation premium RP = Interest rate risk premium
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Modern Term Structure Theories

Theory # 2
The previous equation showed the component of interest rates on default-free bonds that trade in a liquid market. Not all bonds are risk free.
Therefore, a liquidity premium (LP) and a default premium (DP) must be added to the previous equation:
NI = RI + IP + RP + LP + DP
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Why The Term Structure of Interest Rates is Important?

For Business & Individuals
It helps in investment decisions, as cash is most unproductive asset so it is more profitable for business to invest in different securities. Term structure helps in making decisions about investment in securities (short term vs long term).
For Government
Issue short term T-bills or long term bonds?
Finally it is helpful in forecasting future interest rates, which
help businesses in financial planning and decision making.
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The End
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Overview of Interest Rate

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By: Hyder Ali Khawaja

Interest Overview (Cont..)

The Allocative Role of Interest

Allocate Role of Interest

Determination of the Market Rate of Interest

Determination of the Market Rate of Interest (Cont..)

Determination of the Market Rate of Interest (Cont..)

Net Savers Households Businesses Government

Determination of the Market Rate of Interest (Cont..)

Who demand credit?

Determination of the Market Rate of Interest (Cont..)

Determination of the Market Rate of Interest (Cont..)

Determination of the Market Rate of Interest (Cont..)

The Market Rate of Interest

Equilibrium Interest Rate

Equilibrium Interest Rate (Cont..)

Real money supply

Aggregate real money demand, L(R,Y)

Real money holdings

Equilibrium Interest Rate (Cont..)

Equilibrium Interest Rate (Cont..)

Real money supply

Real money supply increase

Real money holdings

Equilibrium Interest Rate (Cont..)

Equilibrium Interest Rate (Cont..)

Equilibrium Interest Rate (Cont..)

Equilibrium Interest Rate (Cont..)

Equilibrium Interest Rate (Cont..)

Equilibrium Interest Rate (Cont..)

Equilibrium Interest Rate (Cont..)

Note: 35 At 30 5% Money demanded 25 Is equal 20 to 15 Money supplied

Money Demanded Md (I) = 45 5I (In million rupees)

Money Supplied Ms (I)= 5 + 3I (In million rupees)

Money Market (Cont..)

Amount of money demanded (billions of rupees)

Money Market (Cont..)

Amount of money demanded (billions of rupees)

Money Market (Cont..)

Amount of money demanded (billions of rupees)

Money Market (Cont..)

Amount of money demanded (billions of rupees)

Money Market (Cont..)

Money Market (Cont..)

Money Market (Cont..)

Nominal versus Real Interest Rate

Real Interest Rate

Nominal versus Real Interest Rate

Nominal versus Real Interest Rate

Nominal versus Real Interest Rate

Nominal Rate = 10% Inflation (CPI) = 6% Real Rate = ?

Real Rate = [1.1/1.06] 1

Nominal versus Real Interest Rate

Nominal versus Real Interest Rate

Ex Ante. Vs. Ex Post

The difference between the two depends on the

accuracy of inflationary expectations

Inflation Expectations and Real Returns

Types of Nominal Interest Rates

Types of Nominal Interest Rates (Cont..)

Types of Nominal Interest Rates

Determinants of Customer Creditworthiness

Types of Nominal Interest Rates (Cont..)

Types of Nominal Interest Rates (Cont..)