Points of Interest is one of a series
of essays adapted from articles in
On Reserve, a newsletter for economic
educators published by the Federal
Reserve Bank of Chicago. The original
article was written by Keith Feiler
and revised by Tim Schilling.
For additional copies of this essay —
or for information about other Federal
Reserve publications on money and
banking, the financial system, the
economy, consumer credit, and
other related topics — contact:
Public Information Center
Federal Reserve Bank of Chicago
P.O. Box 834
Chicago, IL 60690-0834
Tel. (312) 322-5111
Interest rates can significantly influence people’s
behavior. When rates decline, homeowners rush to buy
new homes and refinance old mortgages; automobile
buyers scramble to buy new cars; the stock market soars,
and people tend to feel more optimistic about the future.
But even though individuals respond to changes in
rates, they may not fully understand what interest rates
represent, or how different rates relate to each other.
Why, for example, do interest rates increase or decrease?
And in a period of changing rates, why are certain rates
higher, while others are lower?
% = ?
To answer these questions, we must separate movements in the general
level of interest rates from differences in individual rates. As we can see in
the chart below, rates rose steadily from 1979 to 1981 and generally fell after
that, with a few upward turns to break the downward trend. Because interest
rates tend to move together, we can characterize certain periods as times of
high or low interest rates. For example, in 1981 the general level of interest
rates was higher than the general level in 1993.
As we also can see in the chart, however, individual rates tend to differ,
even though they are moving in the same general direction. Thus a 30-year
Treasury bond may have a higher rate than a 3-month certificate of deposit.
Similarly, a mortgage loan may have a lower rate than an automobile loan.
These similarities and differences are not determined by luck, coincidence,
a world conspiracy of money barons, or even the Federal Reserve. Rather,
they are determined by strong, impersonal economic forces in the market-
place, which reflect the personal choices of millions of individual borrowers
This publication is intended to help you better understand interest
rates and how they are influenced by these economic forces. The first section,
Levels of Interest, examines the forces that determine the general level of
rates. This section discusses basic factors of supply and demand for funds
and the function of banks and other similar institutions in meeting the
needs of savers and borrowers. It also examines other factors such as fiscal
policy and the actions of the Federal Reserve System.
The second section, Different Interests, examines the variations among
individual rates, explaining why a 6-month Treasury bill may have one rate,
business loans another, and home mortgages still a third. This section discusses
the unique characteristics of each credit transaction, such as risk, rights, and
tax considerations, and how these factors affect the decision-making process
of borrowers and lenders.
Interest Rate Trends
Conventional Mortgage 3-month CDs
30-year Treasury Bonds 3-month Treasury Bills
1979 ’81 ’83 ’85 ’87 ’89 ’91 ’93 ’95 ’97 ’99
Levels of Interest
The Price of Credit price the borrower must pay for
the immediate use of the lender’s
To understand the economic forces
funds. Put more simply, interest
that drive (and sometimes are
rates are the price of credit.
driven by) interest rates, we first
need to define interest rates. An
interest rate is a price, and like any Supply and Demand
other price, it relates to a transaction As with any other price in our
or the transfer of a good or service market economy, interest rates are
between a buyer and a seller. This determined by the forces of supply
special type of transaction is a loan and demand, in this case, the supply
or credit transaction, involving a of and demand for credit. If the
supplier of surplus funds, i.e., a supply of credit from lenders rises
lender or saver, and a demander of relative to the demand from bor-
surplus funds, i.e., a borrower. rowers, the price (interest rate)
In a loan transaction, the will tend to fall as lenders compete
borrower receives funds to use for to find use for their funds. If the
a period of time, and the lender demand rises relative to the supply,
receives the borrower’s promise to the interest rate will tend to rise as
pay at some time in the future. borrowers compete for increasingly
The borrower receives the bene- scarce funds. The principal source
fit of the immediate use of funds. of the demand for credit comes from
The lender, on the other hand, gives our desire for current spending
up the immediate use of funds, for- and investment opportunities.
going any current goods or services The principal source of the
those funds could purchase. In supply of credit comes from savings,
other words, lenders loan funds they or the willingness of people, firms,
have saved—surplus funds they do and governments to delay spending.
not need for purchasing goods or Depository institutions such as
services today. banks, thrifts, and credit unions, as
Because these lenders/savers well as the Federal Reserve, play
sacrifice the immediate use of funds, important roles in influencing the
they ask for compensation in addition supply of credit.
to the repayment of the funds loaned. Let’s examine these sources.
This compensation is interest, the
The Source of Demand if they have an opportunity they
believe will earn more—that is,
Consumption. At one time or
create a larger income stream—
another, virtually all consumers,
than they will have to pay on the
businesses, and governments
loan, or than they will receive in
demand credit to purchase goods
some other activity.
and services for current use. In
Say, for example, a widget
these loans, borrowers agree to pay
manufacturer sees an opportunity
interest to a lender/saver because
to purchase a new machine that
they prefer to have the goods or
can reasonably be expected to earn
services now, rather than waiting
a 20 percent return, i.e., produce
until some time in the future when,
income from the manufacture of
presumably, they would have saved
widgets equal to 20 percent of the
enough for the purchase. To describe
cost of the machine. The manu-
this preference for current consump-
facturer will borrow funds only if
tion, economists say that borrowers
they can be obtained at an interest
have a high rate of time preference.
rate less than 20 percent.
Expressed simply, people with
What borrowers are willing to
high rates of time preference prefer
pay, then, depends principally on
to purchase goods now, rather than
time preferences for current con-
wait to purchase future goods—
sumption and on the expected rate
an automobile now rather than an
of return on an investment.
automobile at some time in the
future, a current vacation opportu-
nity rather than a future opportunity, The Source of Supply
and present goods or services The supply of credit comes from
rather than those in the future. savings—funds not needed or used
Although lenders/savers for current consumption. When we
generally have lower rates of time think of savings, most of us think
preference than borrowers, they of money in savings accounts, but
too tend to prefer current goods this is only part of total savings.
and services. As a result, they ask All funds not currently used
for the payment of interest to en- to purchase goods and services are
courage the sacrifice of immediate part of total savings. For example,
consumption. As a lender/saver, insurance premiums, contributions
for example, one would prefer not to to pension funds and social security,
spend $100 now only if the money funds set aside to purchase stocks
was not needed for a current pur- and bonds, and even funds in our
chase and one could receive more checking accounts are savings.
than $100 in the future. Since most of us use funds in
Investment. In the use of funds for checking accounts to pay for current
investment, on the other hand, time consumption, we may not consider
preference is not the sole factor. them savings. However, funds in
Here consumers, businesses, and checking accounts at any time are
governments borrow funds only considered savings until we transfer
them out to pay for goods and
Savings Checking Insurance
Most of us keep our savings in Banks create deposits by mak-
financial institutions like insurance ing loans. Rather than handing
companies and brokerage houses, cash to borrowers, banks simply
and in depository institutions such increase balances in borrowers’
as banks, savings and loan associa- checking accounts. Borrowers can
tions, credit unions, and mutual then draw checks to pay for goods
savings banks. These financial and services. This creation of check-
institutions then pool the savings ing accounts through loans is just
and make them available to people as much a deposit as one we might
who want to borrow. make by pushing a ten-dollar bill
This process is called financial through the teller’s window.
intermediation. This process of With all of the nation’s banks
bringing together borrowers and able to increase the supply of credit
lenders/savers is one of the most in this fashion, credit could con-
important roles that financial insti- ceivably expand without limit.
tutions perform. Preventing such uncontrolled
expansion is one of the jobs of the
Federal Reserve System (the Fed),
Banks and Deposit
our central bank and monetary
authority. The Fed has the respon-
Depository institutions, which for sibility of monitoring and influenc-
simplicity we will call banks, are ing the total supply of money
different from other financial insti- and credit.
tutions because they offer trans-
action accounts and make loans
by lending deposits. This deposit
The General Level
creation activity, essentially creating of Rates
money, affects interest rates because The general level of interest rates
these deposits are part of savings, is determined by the interaction of
the source of the supply of credit. the supply and demand for credit.
When supply and demand interact, lenders, seeking to protect their
they determine a price (the equili- purchasing power, add the expected
brium price) that tends to be rate of inflation to the interest rate
relatively stable. However, we have they demand. Borrowers are willing
seen that the price of credit is not nec- to pay this higher rate because they
essarily stable, implying that some- expect inflation to enable them to
thing shifts the supply, the demand, repay the loan with cheaper dollars.
or both. Let’s examine several If lenders expect, for example,
factors that influence these shifts. an eight percent inflation rate for the
Expected Inflation. As we have coming year and otherwise desire
already seen, interest rates state the a four percent return on their loan,
rate at which borrowers must pay they would likely charge borrowers
future dollars to receive current 12 percent, the so-called nominal
dollars. Borrowers and lenders, how- interest rate (an eight percent infla-
ever, are not as concerned about tion premium plus a four percent
dollars, present or future, as they “real” rate).
are about the goods and services Borrowers and lenders tend to
those dollars can buy, the purchas- base their inflationary expectations
ing power of money. on past experiences which they
Inflation reduces the purchas- project into the future. When they
ing power of money. Each percent- have experienced inflation for a
age point increase in inflation long time, they gradually build the
represents approximately a 1 inflation premium into their rates.
percent decrease in the quantity Once people come to expect a certain
of real goods and services that can level of inflation, they may have to
be purchased with a given number experience a fairly long period at a
of dollars in the future. As a result, different rate of inflation before they
are willing to change the inflation
The effect of an inflation
The Fed and Bank Reserves premium can be seen in the chart
The Fed affects the general level of interest rates by influencing at right. Although the chart tracks
the total supply of money and credit that banks can create. When the consumer price index or CPI
banks create checkbook deposits, they create money as well as and the constant maturity 3-year
credit since these deposits are part of the money supply. Treasury note rate, one could use
almost any inflation measure and
The Fed exerts this influence on the supply of money and
interest rate and see a similar
credit by affecting bank reserves. These reserves are funds that
pattern. As inflation rose through the
banks are required to hold in the form of either cash in their own late 1970s, it came to be “expected”
vaults or as a balance at a Fed Bank. by lenders as well as borrowers.
Banks are required to hold a level of reserves equal to a This “inflation expectation” can be
proportion of deposits on their books. For example, a required seen by the fact that investors in
reserve ratio of 10 percent means that a bank must set aside Treasury notes were demanding a
one dollar for every ten deposit dollars. In other words, a bank relatively high inflation premium
in the early 1980s, even after infla-
cannot owe ten deposit dollars unless it holds one reserve dollar.
tion reached its apex. This was
Hence legal reserve requirements, combined with the given level
of reserves, set limits on the amount of credit banks can offer.
partially due to the fact that Economic Conditions. All busi-
relatively high levels of inflation nesses, governmental bodies, and
Inflation were fresh in the memories of households that borrow funds
borrowers and lenders, and there affect the demand for credit. This
was uncertainty as to how serious demand tends to vary with general
5¢ policymakers would be in pursuing
lower levels of inflation. In 1984,
When economic activity is ex-
1945 for example, it took only a slight panding and the outlook appears
increase in inflation to cause a rela- favorable, consumers demand sub-
tively rapid increase in interest rates. stantial amounts of credit to finance
For most of the 1980s, inflation homes, automobiles, and other
was relatively low and interest major items, as well as to increase
rates continued their downward current consumption. With this
trend with the gap between rates positive outlook, they expect higher
95 ¢ and inflation narrowing. As the incomes and as a result are generally
1995 memory of high inflation receded, more willing to take on future
so did pressure for a high inflation obligations. Businesses are also
premium, as indicated by the rela- optimistic and seek funds to finance
tively modest rise in rates when the additional production, plants,
inflation flared in 1990. Inflationary and equipment needed to supply
expectations had been reduced, a this increased consumer demand.
goal sought by many monetary All of this makes for a relative
policymakers. Indeed, Fed Chairman scarcity of funds, due to increased
? Alan Greenspan has stated that demand.
2045 price stability would be achieved On the other hand, when sales
when the expectation of future are sluggish and the future looks
price changes plays no role in the grim, consumers and businesses
decisionmaking of businesses and tend to reduce their major purchases,
households. and lenders, concerned about the
repayment ability of prospective
borrowers, become reluctant to
Effect of Inflation Premium
3-year Treasury Constant Maturity
CPI Year-to-year Change
1979 ’81 ’83 ’85 ’87 ’89 ’91 ’93 ’95 ’97 ’99
lend. As a result, both the supply Fiscal Policy. Federal, state and
of and demand for credit may fall. local governments, through their
Unless they both fall by the same fiscal policy actions of taxation
amount, interest rates are affected. and spending, can affect either the
Federal Reserve Actions. As we supply of or the demand for credit.
have seen, the Fed acts to influence If a governmental unit spends less
the availability of money and credit than it takes in from taxes and other
by adjusting the level and/or price sources of revenue, as many have
of bank reserves. The Fed affects in recent years, it runs a budget
reserves in three ways: by setting surplus, meaning the government
reserve requirements that banks has savings. As we have seen, sav-
must hold, as we discussed earlier; ings are the source of the supply
by buying and selling government of credit. On the other hand, if a
securities (usually U.S. Treasury governmental unit spends more
bonds) in open market operations; than it takes in, it runs a budget
and by setting the “discount rate,” deficit, and must borrow to make
which affects the price of reserves up the difference. The borrowing
banks borrow from the Fed through increases the demand for credit,
the “discount window.” contributing to higher interest rates
These “tools” of monetary in general.
policy influence the supply of
credit, but do not directly impact Interest Rate
the demand for credit. Because the Predictions
Fed directly affects only one side of
The level of interest rates influences
the supply and demand relationship,
people’s behavior by affecting
it cannot totally control interest rates.
economic decisions that determine
Nevertheless, monetary policy
the well-being of the nation: how
clearly does affect the general level
much people are willing to save,
of interest rates.
and how much businesses are will-
ing to invest.
With so many important deci-
sions based on the level of interest
rates, it is not surprising that people
want to know which way rates are
going to move. However, with so
many diverse elements influencing
rates, it is also not surprising that
people are not able to predict the
direction of these movements
Even though we are not able
to predict accurately and consis-
tently how interest rates will move,
these movements are clearly not
random. To the contrary, they are
strictly controlled by the most
calculating master of all—the
economic forces of the market.
As we have seen, certain factors Credit Transactions
affect the general level of interest
As different as all these transactions
rates. But why do the rates vary for
may at first appear, they are the
different transactions? For example,
same in one respect—they all in-
on a typical day at a local financial
volve borrowing and lending funds.
institution, a lending officer might
Each transaction has a lender, who
approve a $20,000 loan to the local
exchanges funds for an asset in the
school board for emergency repairs
form of an IOU or credit, and a
on the school’s furnace and charge
borrower who exchanges the IOU
the board 8 percent interest for the
for funds. Because credit, the IOU,
use of the funds. Later, the banker
is being bought and sold, these are
might approve a used-car loan for
called credit transactions. Most of
$4,000, at 11 percent interest, to be
us can easily see that the loan officer
paid in three years, and a small
is providing credit—the bank is
business loan for $17,000, at 8.5 per-
lending money to the school board,
cent interest, for a term of four years.
the person buying the used car, and
Meanwhile, the bank’s invest-
ment officer submits a bid for a
The other transactions are also
two-year Treasury note on which
credit transactions, although we
the bank wants to receive 6 percent
generally think of them in different
interest, and purchases a 15-year
terms. We usually refer to the pur-
general obligation municipal bond
chase of a Treasury note or a muni-
issued by the local city government.
cipal bond as making an investment,
The bank will receive 8 percent
but they are credit transactions
interest on this bond. At the next
because the bank is loaning money
desk, the new accounts officer
to the federal and city governments.
opens an interest-paying checking
By investing in the note and bond,
account, which will pay a customer
the bank makes funds available
1.5 percent interest.
directly to the government (or in-
directly by replacing the previous
holder of the government’s debt).
The bank, in return, receives inter-
est payments from the government.
When the new accounts officer
opened the checking account for
the customer, the bank gained the
use of funds. This, too, is a credit
transaction in which the customer
is the lender and the bank is the
borrower. To compensate for the use
3 years of funds, the bank pays interest.
Degrees of Interest will go at the drop of a hat.
In credit transactions, too, people
Although all the transactions at
are willing to accept different levels
the bank that morning were credit
of risk. However, most people are
transactions, they all involved
risk averse; that is, they prefer not
different interest rates, different
to increase risks with their money
prices of credit. As with other prices
unless they receive increased
in a free market system, interest rates
are determined by many factors.
To illustrate, let’s say we have a
As we’ve seen, some factors are
choice of buying two debt securities,
more or less the same for all credit
which are bonds or IOUs issued
transactions. General economic
by corporations or governments
conditions, for example, cause all
seeking to borrow funds. One
interest rates to move in the same
security pays (meaning, we will
direction over time.
receive) a certain five percent
Other factors vary for different
interest, while the other has a 50
kinds of credit transactions, causing
percent chance of paying eight
their interest rates to differ at any
percent interest and a 50 percent
one time. Some of the most impor-
chance of paying two percent. Which
tant of these factors are:
security should we buy? If we are
• different levels and kinds of risk;
risk averse investors/lenders, we
• different rights granted to
would choose the security paying
borrowers and lenders, and
the certain five percent, because we
• different tax considerations.
would not view the uncertainty of
Let’s examine each of these.
return on the second security as an
Levels of Risk If, on the other hand, the second
Risk refers to the chance that some- security has a 50 percent chance of
thing unfavorable may happen. paying 15 percent interest and a
If you go skydiving, the risks you 50 percent chance of paying two
assume are obvious. When you percent, we might be inclined to
purchase a financial asset, say by buy it because we might consider
lending funds to a corporation by the higher potential return to be
purchasing one of its bonds, you worth the risk.
also take a risk—a financial risk. Even though lenders are will-
Something unfavorable could ing to accept different levels of
happen to your money—you could risk, they want to be compensated
lose all of it if the company issuing for taking the risk. Therefore, as
the security goes bankrupt, or you securities differ in level of risk,
could lose part of it if the asset’s their interest rates tend to differ.
price goes down and you have to Generally, interest rates on debt
sell before maturity. securities are affected by three kinds
Different people are willing to of risk:
accept different levels of risk. Some • default risk,
people will not go skydiving under • liquidity risk, and
any circumstances, while others • maturity risk.
Default Risk loans, for example, the car usually
serves as collateral. Other assurances
For any number of reasons, even the
could include a cosigner, another
most well-intentioned borrowers
person willing to make payment
may not be able to make interest
if the original borrower defaults.
payments or repay borrowed funds
Generally speaking, because secured
on time. If borrowers do not make
loans are comparatively less risky,
timely payments, they are said to
they carry a lower interest rate than
have defaulted on loans. When
borrowers do not make interest
As a borrower, the federal
payments, lenders’ returns (the
government offers firm assurances
interest they receive) are reduced
against default. As a result of the
or wiped out completely; when
power to tax and authority to coin
borrowers do not repay all or part
money, payments of principal and
of the principal, the lenders’ return
interest on loans made to (or secu-
is actually negative.
rities purchased from) the U.S.
All loans are subject to default
government are, for all practical
risk since borrowers may die, go
purposes, never in doubt, making
bankrupt, or be faced with un-
U.S. government securities virtually
foreseen problems that prevent
default-risk free. Since investors
payments. Of course, default risk
tend to be risk averse and U.S.
varies with different people and
government securities are all but
companies; nevertheless, no one
free from default risk, they generally
is free from risk of default.
carry a lower interest rate than
While investors/lenders accept
securities from corporations.
this risk when they loan funds, they
Similarly, other types of bor-
prefer to reduce the risk. As a result,
rowers represent different levels of
many borrowers are compelled to
risk to the lender. In each case, the
secure their loans; meaning, they
lender needs to evaluate what are
give the lender some assurances
commonly called “the three Cs”
against default. Frequently, these
of character, capital, and capacity.
assurances are in the form of collat-
Character represents the borrower’s
eral, some physical object the lender
history with previous loans. A
can possess and then sell in the
history containing bankruptcies,
event of default. For automobile
repossessions, consistently late traded security of a well-known
or missed payments, and court company, which we know we can
judgments may indicate a higher sell easily at a price close to our
risk potential for the lender. purchase price. If we are risk averse,
Capital represents current financial we would choose the security from
condition. Is the borrower currently the well-known company if both
debt-free, or relatively so in com- were paying the same interest rate.
parison with assets? They may To encourage us to buy its
represent a party with “thrifty” security, the obscure company must
habits, who can take on additional pay a higher rate to compensate us
debt without imposing an undue for the difficulty we will experience
burden on other assets. Capacity if we want to sell.
represents the future ability to
service the loan, i.e., make princi-
pal and interest payments. Income,
job stability, regular promotions, Credit transactions usually involve
and raises are all indicators to lending/borrowing funds for an
be considered. agreed upon period of time. At the
end of that time the loan is said to
have matured and must be repaid.
Liquidity Risk The length of maturity is a source of
In addition to default risk, liquidity another kind of risk—maturity risk.
risk affects interest rates. If a secu- Long-term securities are sub-
rity can be quickly sold at close ject to more risk than short-term
to its original purchase price, it is securities because the future is
highly liquid; meaning, it is less uncertain and more problems can
costly to convert into money than arise the longer the security is
one that cannot be sold at a price outstanding. These greater risks
close to its purchase price. There- usually, but not always, result in
fore, it is less risky than one with a higher rates for long-term securities
wide spread between its purchase than for short-term securities.
price and its selling price. To illustrate, let’s examine U.S.
To illustrate, let’s say that we government securities—Treasury
have a choice between purchasing bills (with original maturities of
an infrequently-traded security of one year or less), Treasury notes
an obscure company, and a broadly- (with original maturities of two to
ten years), and Treasury bonds
(with original maturities of over
ten years). These securities are
quite similar, except in length of
maturity. As we have seen, U.S.
government securities are virtually
default-risk free, and because there
is such a large and active market
for them, they are also virtually
%1 Year Treasury Bill
%% 5 Year Treasury Note
Time to Maturity
15 Year Treasury Bond
If default and liquidity were months, throughout the term of
the only kinds of risk in holding the loan. Some of these bonds are
government securities, we would issued with attached coupons,
be inclined to think that they all which lenders can clip and send in
would have the same interest rate. every six months or year to collect
However, because of maturity risk, the interest that is due.
short-term Treasury bills usually Zero-coupon bonds, however,
pay less (have a lower interest rate) make no interest payments through-
than longer-term Treasury notes out the life of the loan. Rather than
and bonds. pay interest, these bonds are sold
at a price well below their stated
face value. Although not usually
thought of in such terms, a savings
Risk is not the only reason credit bond is like a zero-coupon bond
transactions can have different rates in that it renders one payment at
of interest. As we have seen, certain maturity.
assurances, such as securing loans, Even though zero-coupon
also affect rates. Typically, borrowers bonds make no interest payments,
write these assurances into their debt investors/lenders still need to
securities specifying the rights of know the return on these bonds
both borrower and lender. Because so they can compare it to the
these rights differ, debt securities return on a coupon bond or other
tend to pay different rates of inter- alternative investment. To figure
est. Let’s look at some of these the return, or yield, investors com-
rights in the more common debt pare the difference between their
securities. purchase price and selling price.
Coupon and zero-coupon bonds. Since zero-coupon bonds
Most debt securities promise to provide lenders no compensation
repay the amount borrowed (the until the end of the loan period,
principal) at the end of the length borrowers issuing these bonds tend
of the loan, and also pay interest at to pay a higher rate than borrowers
specified times, such as every six issuing coupon bonds.
Convertible bonds. Some borrowers Call provisions. Some bonds are
sell bonds that can be converted callable after a specified date; that
into a fixed number of shares of is, the borrower has the right to
common stock. With convertible pay off part or all of it before the
bonds, a lender (bondholder) can scheduled maturity date. Unlike
become a part owner (stockholder) convertible bonds which give
of the company by converting the certain rights to the lenders, call
bond into the company’s stock. provisions give borrowers certain
Because investors generally view rights, the right to call the bond.
this right as desirable, borrowers As a result, borrowers must pay a
can sell convertible bonds at a higher interest rate than on similar
lower interest rate than they would securities without a call provision.
otherwise have to pay for a similar
bond that was not convertible.
In addition to the level and kinds of risk and the different rights
granted by different debt securities, taxes also play a significant
Initial Investment role in affecting rates of return.
To illustrate, let’s say you borrow $1,000 for a year at 10
percent interest. At the end of the year, you pay the $1,000 principal
plus $100 interest. However, if the lender is in a 25 percent tax
bracket, the lender will pay $25 in taxes on that $100. Thus,
the lender’s actual after-tax yield is reduced from 10 percent to
Different debt securities carry different tax considerations.
Corporate bonds (loans to corporations) are subject to local, state,
$100 pre-tax return and federal taxes. U.S. government securities are subject to
(Principal plus 10% interest
after one year) federal taxes, but exempt from local and state taxes. Municipal
bonds are exempt from federal taxes, and in some states, exempt
from local taxes.
Taking taxes into consideration, a lender will receive more
after-tax interest income from a municipal bond paying 10 percent
$1,075 than from a corporate bond paying the same rate. This special
tax-exempt status of municipal bonds enables state and local
governments to raise funds at a relatively lower interest cost.
On the other hand, for corporations to attract lenders, they
$75 return after taxes
must pay a higher rate of interest to compensate for taxes.
(At 25% tax rate)
Of course, borrowers will call is issued. As a result, general obliga-
(redeem) only when it is to their tion bonds usually pay a lower rate
benefit. For example, when the of interest than revenue bonds.
general level of interest rates falls,
the borrower can call the bonds
paying high rates of interest and
reborrow funds at the lower rate. With so many different interest
As partial compensation to rates and so many different factors
the lender, the borrower often has affecting them, it may seem that
to pay a penalty to call a bond. borrowing and lending would
Naturally, a borrower will call a be hopelessly complicated and in-
bond only if the advantages of efficient. In reality, however, the
doing so outweigh the penalty. In variety of interest rates reflects
other words, interest rates would the efficiency of the market in
have to fall sufficiently to compen- allocating funds.
sate for the penalty before a bor- In analyzing investment
rower would call a bond. opportunities, lenders look for an
interest rate high enough to account
Municipal bonds. Municipal bonds
for all their risks, rights, and taxes,
are debt securities issued by local
as we have discussed. If the project
and state governments. Usually
will not pay that rate, they will look
these governmental bodies issue
for other investments. For their
either general obligation bonds or
part, borrowers will undertake
only projects with returns high
General obligation bonds, the
enough to cover at least the cost
more common type, are issued for
of borrowed funds.
a wide variety of reasons, such as
The market, then, serves to
building schools and providing
assure that only worthwhile projects
social services. They are secured
will be funded with borrowed funds.
by the general taxing power of
In other words, market forces and
the issuing government.
differences in interest rates work
Revenue bonds, on the other
together to foster the efficient
hand, are issued to finance a specific
allocation of funds.
project—building a tollway, for
example. The interest and principal
are paid exclusively out of the
receipts that the project generates.
Both kinds of municipal bonds
are considered safe. However,
because general obligation bonds
are secured by the assets of the
issuing government and the power
of that government to tax, they
are usually considered safer than
revenue bonds, whose payments
must come out of receipts of the
specific project for which the bond
For information about how to order these materials, contact the Federal
Reserve Bank of Chicago’s Public Information Center, 230 South LaSalle St.,
Chicago, IL 60604, (312) 322-5111.
The ABCs of Figuring Interest
Public Affairs Department
Federal Reserve Bank of Chicago
230 South LaSalle St.
Chicago, IL 60604
(Reprint due summer 2000)
Public Affairs Department
Federal Reserve Bank of Chicago
230 South LaSalle St.
Chicago, IL 60604
Federal Reserve Bank of Chicago
230 South LaSalle Street
Chicago, IL 60604-1413
Web: http://www.frbchi.org October 2000 30m