Behavior of Interest Rates

3 Key excerpts on "Behavior of Interest Rates"

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  eBook - PDF

  Financial Institutions

  Markets and Money

  • David S. Kidwell, David W. Blackwell, David A. Whidbee, Richard W. Sias(Authors)
  • 2020(Publication Date)
  • Wiley

    (Publisher)

  This chapter explains the role of interest rates in the economy and provides a basic explanation of the fundamental determi- nants of interest rates. The chapter serves as a foundation for Chapters 5 and 6, which also deal with interest rates. ■ vectorfusionart/Shutterstock Even though we understand the factors that cause interest rates to change, only people who have a crystal ball can predict interest movements well enough to make consistent profits. The gutters of Wall Street are littered with failed interest rate prediction models. 4.1 WHAT ARE INTEREST RATES? For thousands of years, people have been lending goods to other people, and on occasion, they have asked for some compensation for this service. This compensation is called rent— the price of borrowing another person’s property. Similarly, money is often loaned, or rented, for its purchasing power. The rental price of money is called the interest rate and is usually expressed as an annual percentage of the amount of money borrowed. Thus, an interest rate is the price of borrowing money for the use of its purchasing power. To a person borrowing money, interest is the penalty paid for consuming income before it is earned. To a lender, interest is the reward for postponing current consumption until the maturity of the loan. During the life of a loan contract, borrowers typically make periodic interest payments to the lender. On maturity of the loan, the borrower repays the same amount of money borrowed (the principal) to the lender. Like other prices, interest rates serve an allocative function in our economy. They allocate funds between surplus spending units (SSUs) and deficit spending units (DSUs) and among financial markets. For SSUs, the higher the rate of interest, the greater the reward for postponing current consumption and the greater the amount of saving in the economy.

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  eBook - PDF

  Fundamentals of Corporate Finance

  • Robert Parrino, David S. Kidwell, Thomas Bates(Authors)
  • 2016(Publication Date)
  • Wiley

    (Publisher)

  For example, a major breakthrough in technology should cause a shift to the right in the desired level of borrowing schedule, thus increasing the real rate of interest. This makes intuitive sense because the new technology should spawn an increase in investment opportunities, increasing the desired level of borrowing. Similarly, a reduction in the corporate tax rate should provide businesses with more money to spend on investments, which should increase the desired level of borrowing schedule, causing the real rate of interest to increase. One factor that would shift the desired level of lending to the right, and hence lead to a decrease in the real rate of interest, would be a decrease in the tax rates for individuals. Another would be monetary policy action by the central bank to increase the money supply. Other forces that could affect the real rate of interest include growth in population, demo-graphic variables such as the age of the population and cultural differences. In sum, the real rate of interest reflects a complex set of forces that control the desired level of lending and borrowing in the economy. The real rate of interest has historically been around 3 per cent, but has varied between 2 and 4 per cent because of changes in economic conditions. EXHIBIT 2.5 The Determinants of the Equilibrium Rate of Interest The equilibrium rate of inter-est is a function of supply and demand. Lender-savers are willing to supply more funds as interest rates go up, but borrower-spenders demand fewer funds at higher inter-est rates. The interest rate at which the supply of funds equals the demand for those funds is the equilibrium rate. The amount lender-savers want to lend (L) goes up as interest rates go up and lending becomes more profitable. Equilibrium rate of interest The equilibrium rate of interest ( r ) is the rate at which the desired level of lending (L) equals the desired level of borrowing (B).

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  eBook - ePub

  Predicting Presidential Elections and Other Things, Second Edition

  • Ray Fair(Author)
  • 2011(Publication Date)
  • Stanford Economics and Finance

    (Publisher)

  early Volcker period. We would expect the money supply variable to have more of an effect on the bill rate in this period than either before or after, and we will see that this is the case.

  A key characteristic of Fed behavior is a tendency to change interest rates in small steps. If, for example, the Fed is in the process of raising interest rates, it often does this by raising the federal funds rate by 0.25 percentage points each time the FOMC meets (about every six weeks). The Fed does not appear to like large, abrupt changes in interest rates. This means that the value of the federal funds rate at the time of the meeting has an important effect on the new rate that is set. This is, of course, obvious. When the Fed makes a change, if the size of the change is typically small, then the rate at the time of the meeting has a large effect on the value of the new rate. The Fed’s interest setting behavior is thus influenced by the value of the existing rate at the time of the meeting.

  There are two other timing issues that are relevant for the question of how fast the Fed changes interest rates. First, we will see that the change in the unemployment rate appears to affect Fed behavior. If, for example, the unemployment rate is rising, the Fed appears to lower interest rates, other things being equal. That is, although the Fed tends to change interest rates in small steps, it seems to decrease interest rates faster when the unemployment rate is rising and to increase interest rates faster when the unemployment rate is falling.

  The other timing issue concerns past changes in interest rates. The change in the bill rate last quarter and the change in the preceding quarter appear to affect the Fed’s current choice of the rate. We will not say much about these timing issues. They are not the most important features of Fed behavior, which are the Fed’s concerns with inflation and unemployment, but we will see that the timing variables are significant.

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