Interest Determining Interest Rates Money Banking ECO 473 Dr D Foster by linzhengnd

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									Determining

        Interest
                            Rates

  Money & Banking - ECO 473 - Dr. D. Foster
 Bond Price will  interest rate

   Monetary policy:

Fed buys bonds - price rises - interest
  rates fall - spending rises -  GDP

Fed sells bonds - price falls - interest
  rates rise - spending falls -  Inflation
    The Loanable Funds Theory

 Real interest rates (r) are determined by
  the supply and demand for loans.
 Demand = investment.
       negatively sloped - why?
   Supply = saving + net K flows
       K inflow - foreigners saving here.
       K outflow - we are saving abroad.
       positively sloped - why?
The Market for Loanable Funds
    The Market for Loanable Funds

   The market generates an equilibrium
    expected (ante) real interest rate.
       Why is equilibrium stable?

   Shifts in demand will change equilibrium r.
       For example . . .

   Shifts in supply will change equilibrium r.
       For example . . .
    The Liquidity Preference Theory

   The nominal interest rate (i) is determined
    by the supply and demand for money.
   Money supply = MS and is determined by
    the Federal Reserve.
   Money demand = MD and is used for
    exchange purposes.
        But, i=opportunity cost of holding money.
        Consumers weigh benefits & costs.
        Negatively sloped. Why?
The Market for Money
     Why do Interest Rates differ?

   Default risk
   (Il)liquidity risk
   “Risk premium” = i - iT-Bill
       where the T-Bill is the riskless rate.

   How do you distinguish default from
    liquidity risk?
             Dealing with Risk




Risk as an example of asymmetric information, where bond
  rating services are the market solution for this problem.
Case:
GM Bond Rating
                      Quick Hits

   Fisher equation: i = r + e
       Market for LF determines r.
       “r” is ex ante – before the fact.
       e can be based on adaptive/rational expectations.

   Adjusting for risk premiums, i still differs …
       by maturities; aka “term structure of interest rates.”
       a positive “term premium”  normal yield curve.
       a negative “term premium”  inverted yield curve.
Term Structure of Interest Rates
     Causes of the term structure

   Segmented markets
       Different terms are not good substitutes.
   Expectations
       If we expect r to rise, longer-term bonds will
        earn a higher interest rate.
   Preferred habitat
       Longer terms require a premium . . . usually.
   [Unanticipated] Inflation premium . . .
    Unanticipated Inflation Premium
 Consider a 1 yr. bond and a perpetuity
 Let i=5% which includes =2%
 Bond has F=$100 so P=105/1.05=$100
 Perpetuity has C=$5 so P=$5/.05 =$100

   If  rises to 4% . . .
       Bond price will fall to $105/1.07 = $98.13
       Perpetuity price falls to $5/.07 = $71.43
   So, interpret yield curve w.r.t. ua.
Determining

        Interest
                            Rates

  Money & Banking - ECO 473 - Dr. D. Foster

								
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