Transcript Chapter 4

The Level of Interest Rates
Chapter 4
FIN 221
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Dr. Hisham Abdelbaki - FIN 221 - Ch. 4
What are Interest Rates?
• Interest rates are:
1. The price of borrowing money for the use of its
purchasing power (it is the rental price of money).
2. To a borrower, they are penalty for consuming
income before it is earned.
3. To a lender , they are reward for postponing
current consumption until the maturity of the
loan.
4. Interest rates serve an Allocative Function in the
economy. They allocate funds between SSUs and
DSUs and among
financial markets.
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Determine the interest Rate in the LR
• Two Main factors effect on interest rate on deposits:
1- Return on investment (upper limit on interest rate can
be paid to savers)
2- positive time preference for consumption (how much
consumption consumers are willing to forgo at different
interest rate levels)
• Equilibrium real interest rate is the intersection point
between demand for funds (Investment curve) and supply
of funds (Saving curve)
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• Factors effect on return on investment then on demand
for fund. So demand curve will shift either to the right or
to the left:
1.
2.
3.
4.
5.
Productivity
Technology
taxes,
expected risk
expected sales
• Factor effect on supply of funds. so supply of funds
curve will shift either rightward or leftward:
1. Consumer attitude (propensity to save)
2. personal Income,
3. personal income tax
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• Examples:
1- draw an equilibrium position between demand and
supply of funds indicating the equilibrium interest rate.
2- show and explain the effects of the following on
equilibrium position:
a) Improvement in technology
b) increase in taxes on business
c) increase in taxes on personal income
d) expect more sales in the future
e) Increase in real interest rate
f) Decrease propensity to save
g) Expect less risk in the future
h) Discover a new machine that will increase the
productivity
i) The economy will enter a recession stage that will
effect on income and sales
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Determine the Interest Rate in the SR
(Theory of Loanable Funds)
• In the short run, interest rate depends on
the supply of and the demand for loanable
funds.
• The supply of and the demand for loanable
funds depend on productivity and thrift.
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Sources of Demand and Supply of Loanable
Funds
• Sources of Supply loanable Funds
 Consumer savings.
 Business savings
 Government savings
 Central bank, changing quantity of money.
• Sources of Demand Loanable Funds
 Business investment.
 Consumer credit purchase.
 Government budget deficit.
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Factors effect on Supply of Loanable Funds
1. Real Interest rate (Movement)
2. Change in Quantity Supplied of Money
3. Change in the Income tax
4. Change in GOV. Budget (from Deficit to Surplus
Position)
5. Change in Saving Rate
6. Change in Business Savings
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Factors effect on Demand for Loanable Funds
1. Real Interest rate
2. Change in future expected Profits
3. Change in GOV. Budget (from surplus to deficit
position)
4. Change in Taxes
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Excess Supply
Excess
Demand
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Movement Versus Shifting of SL / DL
• Changes in interest rate brings changes in quantity of
LFs demanded and supplied, and thus movements along the
SL and DL curves.
• Changes in factor (s) other than the interest rate will
change the supply / demand for LFs. There will be a shift
in the supply and demand curves, and as a result a new
equilibrium occurs.
• In summary,
1. If SL only increases, …………………..
2. If DL only increases, ………………………
3. If both SL and DL increase, ……………..
Dr. Hisham Abdelbaki - FIN 221 - Ch. 4
4.11 If both SL and DL
decrease, ……………….
Price Expectations and Interest Rate
• Increase prices leads to decrease purchasing power.
• To avoid decrease in purchasing power, compensation should
be added.
• Example:
An SSU and a DSU plan to exchange money and financial claims for
a period of one year. Both agreed that a fair rental price for the money
is 5% and both anticipate an 8% inflation rate during the year. What
would be the contract rate on the loan ?To answer this question we
need to discuss the Fisher Effect.
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The Fisher Effect :
The Fisher Effect Theory states that the nominal interest rate
(contract rate) includes real interest rate (interest rate without
inflation) and expected annual inflation rate.
The Fisher Equation is expressed as:
(1+ i ) = (1+r) ( 1+ ΔPe )
Where : i = the observed nominal rate of interest.
r = real rate of interest in the absence of price level
changes ( interest rate where no inflation exists).
ΔPe = expected annual change in commodity prices
(expected annual rate of inflation).
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Solving the Fisher Equation for (i), we obtain the following
equation:
1 + i = 1 + ΔPe + r + r Δpe
1 – 1 + i = r + ΔPe + r ΔPe
i = r + ΔPe + r Δpe
The final term of the Fisher equation (r ΔPe )is approximately equal
to zero. So, in many situations it is dropped from the equation
without creating a critical error.
The equation without the final term is referred to as the Approximate
Fisher Equation and is stated as :
i = r + Δpe
Note 1 : the nominal interest rate includes: (1) the real interest rate
and (2) the anticipated change in price level over the life of the
contract.`
Note 2: if Δpe equals ZERO, nominal interest rate (i) = real interest
Dr. Hisham Abdelbaki - FIN 221 - Ch. 4
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rate
Example 1:
If real interest rate is 5%, actual inflation last year was 7%,
and expected inflation for the coming year is 9%. What is
the current level of nominal interest rate?
Example 2:
In Example 1, what compensation would a lender require
for lending BD 1000 for 1 year?
Example 3:
If the real interest rate is 6%, actual inflation for the last
year was 5%, and expected inflation is 9% , according to
the fisher effect, what is the current level of nominal
interest rate?
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Example 4:
If you believe that the real of interest is 5% and the
expected inflation rate is 4%, what is the nominal
interest rate?
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The Realized Real Rate
The Fisher equation is based on expected inflation rate.
The actual rate of inflation may be different from the anticipated
rate.
This may lead to the realized rate of return on a loan to be
different from the nominal interest rate agreed on at the
time of the loan contract.
The realized (actual) real rate is calculated as :
r = i - ΔPa,
Where; r = is the realized real rate of return, i = the nominal
interest rate, and ΔPa = is the actual rate of inflation.
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Example 1
An investor earned 12% last year, a year when actual
inflation was 9% and was expected to have been 6%. The
investor realized real return rate was:
Example 2: No. 9 Page 103
An investor buys a 1 –year Treasury security with a
promised yield of 10%. The investor expected the annual
rate of inflation to be 6%; however, the actual rate turned
out to be 10%. What were the expected and the realized
real rates of return for the investor?
• expected real rate =
• realized real rate =
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Example 3
In example 2, assume the actual rate of inflation turned
out to be 12%. What was the realized real rate?
Notice:
The realized real rate may be Positive, Zero or Negative.
1. If nominal interest rate (i) > actual inflation, then
realized real rate is ……………….
2. If nominal interest rate (i) = actual inflation then
realized real rate is ……………….
3. if nominal interest rate (i) ˂ actual inflation then
realized real rate is ……………….
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Example 4:
If actual inflation turns out to be less than
expected inflation, would you rather have been a
borrower or a lender? why?
Example 5:
Magdy lends a 1 –year security to Fahmy with a
promised yield of 10%. The investor expected the
annual rate of inflation to be 6%; however, the
actual rate turned out to be 10%. Who is benefit in
this situation?
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Forecasting Interest Rate
• Two are used by economists to forecast
interest rate:
1. Economic Models
2. Flow of Funds Approach
•
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