# 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.

   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 . . .
 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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