Interest Rates

11 Key excerpts on "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)
  • 2016(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 - ePub

  Money and Banking

  An International Text

  • Robert Eyler(Author)
  • 2009(Publication Date)
  • Routledge

    (Publisher)

  Something we will explore in depth when we talk about money demand later is the idea of the interest rate as the opportunity cost of having cash in your pocket. This relationship between the quantity of cash or liquidity demanded and the interest rate is of key importance to a great deal of macroeconomic theories but also to monetary and fiscal policy in practice. The way consumers react to changes in Interest Rates paid on their cash holdings changes the demand for goods and services, as well as the demand for lending. However, for now the idea is simple: the interest rate is the opportunity cost of holding money in your wallet rather than in an interest-bearing account or investment.

  Measure of time preference

  It is this definition that links the three above and binds them in the household’s eyes. When you chose to consume more than your income, or consume with credit rather than paying in full, you are making a choice about your time preference to consume. The interest rate is a measure of how people prefer to consume with respect to time: if the interest rate falls, there will be marginal changes in consumption based on a smaller cost of credit. Certain households which initially would save, say $1000, now spend $100 of that $1000 and save only $900. They still save a certain amount, but it is less. The lower interest rate has triggered an incentive for them to spend on credit, or prefer to spend now than later in time.

  The cost of borrowing falls in the previous example, providing an incentive to borrow. Certain lenders must provide the loan, thus they see the interest rate as the revenue from lending, and want to take advantage of it. Finally, the borrower must demand cash in order to spend, thus the cost of holding money must also be going down at the same time, and intuitively it does. The interest rate is all four of these ideas simultaneously, and must be for financial markets to work correctly. We will see later that the interest rate’s measure of time preference characteristic makes the entire economy work correctly.

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  Economics for Financial Markets

  • Brian Kettell(Author)
  • 2001(Publication Date)
  • Butterworth-Heinemann

    (Publisher)

  3 The term structure of Interest Rates and financial markets Decisions as to whether to spend or not to spend, whether to borrow (or lend) now or to postpone borrowing (or lending) for six or nine months, whether to buy securities today or hold cash for the present, whether borrowing or lending should be short-term or long-term, are all decisions influenced by current and expected Interest Rates. Interest Rates are at the centre of the key issues in understanding the economics of financial mar-kets. But what are the factors affecting Interest Rates and what exact role do Interest Rates play within the financial system? Functions of Interest Rates Interest Rates serve a number of significant functions. First, they provide investors with a guide for allocating funds among investment opportunities. As funds are directed into projects that have higher expected rates of return (risk and other factors being taken into account), the funds are optimally allocated from the viewpoint of both consumer and investor, since the highest returns normally prevail where effective consumer demand is strongest. Unless an investment opportunity prom-ises a return high enough to pay the market rate of interest, it does not justify the required capital outlay. The money market, by channelling funds into projects that have an expected return in excess of the interest rate, provides a valuable service to investors, borrowers, and society as a whole. The interest rate also provides a measure of the relative advantage of current consumption compared to saving. By adjusting the available market rate for expected inflation and 48 Economics for Financial Markets taxes, an individual can determine the real amount of addi-tional future consumption that can be obtained by postponing current consumption. Similarly, Interest Rates help businessmen decide among alternative production methods. Suppose a product can be made either solely with labour or with a combination of labour and machinery.

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  Money and Calculation

  Economic and Sociological Perspectives

  • M. Amato, L. Doria, L. Fantacci, M. Amato, L. Doria, L. Fantacci(Authors)
  • 2010(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  The points briefly outlined above will be developed in the following sections. I The rate of interest is the price of money. More precisely, it is the price paid for the use of money for a certain time. In still other terms, it is the price paid for the anticipation of a sum of money. Like all other prices, it is traditionally represented by economic theory as the point of intersection between a supply and a demand, where the demand is expressed by those who need the money to finance an economic activ- ity, and who expect to pay the interest from the proceeds of that activ- ity, and the supply is provided by those who have accumulated money, by refraining from expenditure. Like all market prices, the interest rate is assumed to settle at a level where demand equals supply, so as to clear the market. Following this line of reasoning, the classical theory described the market rate of interest as the clearing price for savings and investments. According to this theory, the rate of interest appeared as a remunera- tion for the thrift of the savers, paid by the proceeds of the activities, innovations and progress that were made possible by the anticipation of money to the investors. It was on this basis that, following Locke (1692) and Bentham (1787), the classical economists advocated a liberalization of interest on loans. This was seen as the best way to ensure an adequate incentive for the activity of saving, as a source of finance for economic growth and development. The idea, gradually disseminating common thought and practice, was eventually erected into an economic princi- ple that appeared to reconcile personal and collective interests. Saving, Calculation Implied in the Money Rate of Interest 83 no longer identified with the hideous vice of avarice, became a virtue, public and private; and interest, once banned under the infamous name of usury, became its legitimate reward.

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  Handbook of Singapore — Malaysian Corporate Finance

  • Tan Chwee Huat, Kwan Kuen-Chor, Tan Chwee Huat, Kwan Kuen-Chor(Authors)
  • 2014(Publication Date)
  • Butterworth-Heinemann

    (Publisher)

  Chapter 3 Interest Rates and Credit Mohamed Ariff 3.01 Introduction Financial institutions and markets discussed in the last chapter can be thought of as a loosely organized network for dealing with loanable funds in an economy. The loanable funds form the potential credits available to economic agents, namely, the firms, the government and the individuals. We turn our attention to understanding how Interest Rates determine the amount of loanable funds available as credits for economic activities. Interest Rates may be thought of as the cost of borrowing the funds. Institutions provide a myriad of financial services such as lines of credit, term loans, negotiable certificates of deposits (NCDs), etc at a cost to creditors for making the funds available. Some organizations such as the companies listed in the organized exchanges and the government can issue financial instruments at stated or implied cost for having access to funds. This chapter attempts to describe this process by examining how the Interest Rates are determined in the market. An understanding of this process is very important to investors since Interest Rates will affect the outcomes of various investment activities of firms and individuals. 3.02 Interest Rates Business organizations and the government are the biggest borrowers of funds: the former require funds for undertaking real investments, and the latter for developing the economy and the social structure (education for example). Firms are faced with a number of profitable opportunities which will (1) extend the life of existing productive facilities and (2) offer new opportunities for investment which provide future benefits. These opportunities, let us call them investment schedules, are the objects of choice. Firms bid for funds in the market to undertake investments. Figure 3.1 illustrates the process of estimating the benefits of the investment schedules against the cost of getting these funds: management 39

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  Fundamentals of Corporate Finance

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

    (Publisher)

  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). Equilibrium quantity of lending/ borrowing Interest rate (%) r L = B B L Quantity of lending/borrowing in the economy ($) The amount borrower-spenders want to borrow (B) goes down as Interest Rates go up and borrowing becomes more expensive. 2.7 The Determinants of Interest Rate Levels 53 Loan Contracts and Inflation The real rate of interest ignores inflation, but in the real world, price-level changes are a fact of life and they affect the value of a loan contract or, for that matter, any financial contract. For example, if prices rise (inflation) during the life of a loan contract, the purchasing power of the loaned amount decreases because the borrower repays the lender with inflated money – money that has less buying power. 9 To see the impact of inflation on a loan, we will look at an example. Suppose that you lend a friend €1 000 for one year at a 4 per cent interest rate. Furthermore, you plan to buy a new mountain bike for €1 040 in one year when you graduate from university. With the €40 of interest you earn (€1 000 × 0.04), you will have just enough money to buy the mountain bike. At the end of the year, you graduate and your friend pays off the loan, giving you €1 040. Unfortunately, the rate of infla-tion during the year was an unexpected 10 per cent and your mountain bike now will cost 10 per cent more, or €1 144 (€1 040 × 1.10). You have experienced a 10 per cent decrease in your purchasing power due to the unanticipated inflation. The loss of purchasing power is €104 (€1 144 − €1 040).

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  CFIN

  • Scott Besley, Eugene Brigham, Scott Besley(Authors)
  • 2021(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  115 CHAPTER 5: The Cost of Money (Interest Rates) Copyright 2022 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 3. When the U.S. economy shows signs of expanding too quickly, the Fed normally takes actions to increase Interest Rates to discourage too much expansion and to control future growth so that it does not result in high inflation. 4. During recessions, short-term rates decline more sharply than do long-term rates. This situation occurs for two reasons. First, the Fed operates mainly in the short-term sector, so its intervention has the strongest effect here. Second, long-term rates reflect the average expected inflation rate over the next 20 to 30 years. This expecta- tion generally does not change much, even when the current rate of inflation is low because of a recession. 5-5 INTEREST RATE LEVELS AND STOCK PRICES Interest Rates have two effects on corporate profits. First, because interest is a cost, the higher the rate of inter- est, the lower a firm’s profits, other things held constant. Second, Interest Rates affect the level of economic activity, and economic activity affects corporate profits. Interest Rates obviously affect stock prices because of their effects on profits. Perhaps even more important, they influence stock prices because of competition in the marketplace between stocks and bonds. If Interest Rates rise sharply, investors can obtain higher returns in the bond market, which induces them to sell stocks and transfer funds from the stock market to the bond market.

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  The Pure Theory of Capital

  • F. A. Hayek, Lawrence H. White(Authors)
  • 2011(Publication Date)
  • University of Chicago Press

    (Publisher)

  5 To every increase in the demand for one commodity (or other type of asset) there would correspond an exactly equal decrease in the demand for another kind of commodity. That is, prices would be determined in the same way as in the imaginary barter economy. And, in particular, the demand for investment goods would be exactly equal to that part of their assets which people did not want to have in the form of consumers’ goods. The supply of funds not spent on consumers’ goods would become equal to the demand for such funds at a rate of interest corresponding to the rate of profit as determined by the given prices. There would be differences between the rates of profit people expected to earn in their own businesses and the rates of interest at which they would be willing to lend and to borrow, corresponding to the different degrees of risk. But the net rate of interest would tend to be equal to the net rate of profit. And the relative prices of the various types of goods, and therefore the price differences, would depend solely on the relation of the proportions in which people distributed their money expenditure between consumers’ goods and capital goods to the proportions in which these two types of goods were available.

  Influence of Monetary Changes on Rate of Interest

  While this would undoubtedly be the position once equilibrium had been established, it is one of the oldest facts known to economic theory that changes in the quantity of money, or changes in its ‘velocity of circulation’ (or the ‘demand for money’), will deflect the rate of interest from this equilibrium position and may keep it for considerable periods above or below the figure determined by the real factors. This fact has scarcely ever been denied by economists, and since the time of Richard Cantillon and David Hume6 it has been the subject of theoretical analysis which has been further developed in more recent times,7 particularly by Knut Wicksell and his followers.8 But it has also given rise to a recurrent scientific fashion, from John Law9 down to L. A. Hahn10 and J. M. Keynes, of regarding the rate of interest as being solely dependent on the quantity of money and the varying desires of people to keep certain balances of money in hand.

  We

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  Available until 4 Dec |Learn more

  Monetary Economics

  • Jagdish Handa(Author)
  • 2002(Publication Date)
  • Routledge

    (Publisher)

  part seven

  THE RATES OF INTEREST IN THE ECONOMY

                  Passage contains an image        

  chaptertwenty

  THE MACROECONOMIC THEORY OF THE RATE OF INTEREST

     

  The rate of interest is one of the endogenous variables in the Keynesian and classical models, so that its analysis is properly conducted as part of a complete version of those models. These were presented in Chapters 13 and 14

  .

  This chapter singles out the competing views on the determination of the rate of interest and focuses on their differences and validity. It also highlights the very important difference between the comparative static and the dynamic determination of the rate of interest

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  key concepts introduced in this chapter

  • The Fisher equation of the nominal rate of interest

  • Stocks versus flows of funds

  • The loanable funds theory

  • The liquidity preference theory

  • The excess demand function for bonds

  • The dynamics of interest rate determination

  • The neutrality of money and inflation for the real rate of interest

   

  Macroeconomics avoids the bewildering array of Interest Rates on the numerous assets in the market by focusing on one single rate of interest, without completely specifying which rate of interest it is, as for example in the IS-LM model of Chapters 13 and 14

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  eBook - ePub

  Applied International Economics

  • W. Charles Sawyer, Richard L. Sprinkle(Authors)
  • 2020(Publication Date)
  • Routledge

    (Publisher)

  CHAPTER 15

  Money, Interest Rates, and the exchange rate

  When U.S. Interest Rates have been significantly higher than foreign rates, capital has tended to flow to the United States, raising the value of the dollar; conversely, when U.S. Interest Rates have been significantly below foreign rates, capital has tended to flow abroad, depressing the dollar … the depreciation of the dollar in the late 1970s reflected, among other factors, our expansionary monetary policy. … The reversal of the dollar’s decline in 1980 and its unprecedented appreciation through the middle of the decade reflected major change in U.S. macroeconomic policy … [T]he Federal Reserve initiated policies that led to a substantial rise in U.S. short-term Interest Rates.

  Economic Report of the President

  INTRODUCTION

  S o far, we have examined the institutional details of the foreign exchange market and explained what determines the exchange rate. The model of exchange rate determination developed in the previous chapter explains some of the movement in exchange rates. Both the rate of inflation and the growth rate of GDP usually do not change dramatically over short periods of time, such as one day to the next. Yet, exchange rates change almost every minute of every business day. As a result, we need to expand our model of exchange rate determination to include another factor that determines or influences exchange rate movements over short periods of time. This factor is short-term Interest Rates. Since Interest Rates have an important influence on the exchange rate, we need to describe what causes domestic Interest Rates to change. In the first part of the chapter, we will review and expand on what you learned in your Principles of Economics course concerning the supply and demand for money and the determination of the equilibrium interest rate within a domestic economy.

  In the second part of the chapter, we will examine the relationship between Interest Rates and the exchange rate. As we will see, any change in Interest Rates will lead to changes in the inflows and outflows of capital in a country’s financial account and the changes in capital flows lead to changes in the exchange rate. By the end of the chapter, we will be able to examine how changes in Interest Rates, the exchange rate, the current account, and the financial account all interact with one another.

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  The Evolution of Creditary Structures and Controls

  • G. Gardiner(Author)
  • 2006(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  M ONETARY THEORISTS believe that there will be a much greater inclination to borrow if the interest rate is low. 1 This is an acceptable proposition, for no-one could sensibly deny that the demand for credit would probably be infinite if the nominal interest rate were nil and no repayments were required. The theorists also firmly believe that banks and other lending institutions will be more willing to create money if Interest Rates are high. Lending is a risky business and the risks are more acceptable if the rewards are high. Economists therefore assume that the supply curve for money is one which rises as Interest Rates rise. This proposition too is acceptable provided one remembers that banks are affected in two different ways: on their checking (current) account balances they pay no or little interest, so a rise in the rates they can charge brings a sharp rise in income, a phenomenon known as the endowment effect; on the rest of their deposits they do pay interest, and it is not the absolute level of interest which matters to them, but the margin between what interest rate they charge and what rate they allow. That margin is not a function of the general level of Interest Rates, but of competitive effects. The two propositions above can be illustrated by two graph lines as in Graph 1. The graph assumes that there would still be some supply of credit even at a zero rate of interest. This is because there is always some need for money, regardless of the income it earns, and there will always be people prepared to lend their savings regardless of whether there is any return on them. Indeed experience proves that there will still be a demand for a store of wealth, even if Interest Rates are negative, though the graph does not illustrate that fact. One could claim that the point of intersection of the curves of the graph determines the market rate of interest.

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