Investment Interest Rates

6 Key excerpts on "Investment 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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  Introduction to Finance

  Markets, Investments, and Financial Management

  • Ronald W. Melicher, Edgar A. Norton(Authors)
  • 2020(Publication Date)
  • Wiley

    (Publisher)

  When you decide to invest in your education, you expect that future earnings will be larger, making it easier to repay the student loan. Businesses also borrow to make investments in inventory, plant, and equipment that will earn profits sufficient to pay interest, repay the amount borrowed, and provide returns to equity investors. In this chapter we focus on the cost or price of borrowing funds. An understanding of interest rates—what causes them to change and how they relate to changes in the economy—is of fundamental importance in the world of finance. 8.1 Loanable funds are the amount of money made available by lenders to borrowers. Lenders are willing to supply funds to borrowers as long as lenders can earn a satisfactory return on their loans (i.e., an amount greater than that which was lent). Borrowers will demand funds from lenders as long as bor- rowers can invest the funds so as to earn a satisfactory return above the cost of their loans. Actually, the supply and demand for loanable funds will take place as long as both lenders and borrowers have the expectation of satisfactory returns. Of course, returns received may differ from those expected because of inflation, failure to repay loans, and poor investments. Return experiences will, in turn, affect future supply-and-demand relationships for loanable funds. The interest rate is the price of loanable funds in financial markets. The price that equates the demand for and supply of loanable funds in the financial markets is the equilibrium interest rate. Figure 8.1 depicts how interest rates are determined in the financial markets. Graph A shows the interest rate (r) that clears the market by bringing the demand (D 1 ) by borrowers for funds in equilibrium with the supply (S 1 ) by lenders of funds. For illustrative purposes, we have chosen a rate of 4% as the cost, or price, which makes savings equal to investment (i.e., where the supply and demand curves intersect).

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  Interest Rate Policies in Developing Countries

  • International Monetary Fund(Author)
  • 1983(Publication Date)
  • INTERNATIONAL MONETARY FUND

    (Publisher)

  III Interest Rate Policies and Economic Growth

  Interest rates can have a substantial influence on the rate and pattern of economic growth by influencing the volume and productivity of investment, as well as the volume and disposition of saving. This is especially true for countries where financial markets are relatively well developed or where private investment constitutes a significant share of total investment. Even in countries with less developed financial markets or in those where investment is overwhelmingly the responsibility of the public sector, interest rates may have a significant effect on the mobilization of household savings and on investment decisions. In analyzing this set of issues, it would be useful to distinguish between the effects on saving and those on investment, bearing in mind, however, that while the volume of new investment that can be undertaken is related to the amounts of both foreign borrowing and domestic saving out of current income, it is domestic saving that is by far the more important source of investment financing in most developing countries. Finally, both the savings and investment aspects of interest rate policies influence income distribution, which is treated in the last part of this section.

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  Interest Rate Policies and Savings

  A development strategy that relies on financial savings10 as a major source of investment finance requires price or nonprice incentives in order to stimulate saving in financial form and, where relevant, capital inflows. There is, however, considerable disagreement over the influence exerted by interest rates on the volume of saving: while an increase in interest rates may stimulate saving by making future consumption iess expensive relative to current consumption (substitution effect), it may also tend to reduce saving by lowering the amount of present saving necessary to buy a given amount of future consumption (income effect). The available empirical evidence on the relative importance of these two effects, based largely on the experience of Asian and Latin American countries, suggests that the substitution effect is more important than the income effect in developing countries, although not overwhelmingly so,11

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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 Macroeconomic Environment of Business

  Core Concepts and Curious Connections

  • Maurice D Levi(Author)
  • 2014(Publication Date)
  • WSPC

    (Publisher)

  CHAPTER 7 INTEREST RATES

  “Gentlemen prefer bonds”

  Andrew Mellon

  Key Concepts: Interest rates and the supply of loanable funds; interest rates and the demand for loanable funds; the equilibrium interest rate; the market versus equilibrium interest rate; monetary policy and interest rates; real growth and interest rates; anticipated inflation and interest rates; real versus nominal interest rates; fiscal deficits, crowding-out and interest rates; international capital flows and interest rates.

  THE INTEREST IN INTEREST RATES

  Interest rates have a substantial effect on borrowing and spending decisions of businesses and consumers, and thereby on employment, GDP, and other measures of macroeconomic activity. For example, as we shall see, interest rates influence the willingness of businesses to invest in new plant and equipment, and in turn, the current and future size of the GDP.

  At the same time that interest rates affect the economy, the economy affects interest rates. This occurs as a result of the effects that national income, inflation and confidence about the future have on the willingness of consumers and businesses to borrow and invest, and hence on the price of borrowing, which is the interest rate. With the direction of flow being in both directions, from interest rates to the economy and from the economy to interest rates, in order to explain interest rates we need a theory that captures this two-way flow of influence. Such a theory is the loanable funds theory. While there are numerous other theories of interest rates, the loanable funds theory embraces many aspects of these other theories, and therefore serves as an ideal window onto the world of interest rates.

  LOANABLE FUNDS THEORY OF INTEREST

  According to the loanable funds theory, interest rates are determined by the supply of and demand for loanable funds, which can be thought of as monies that can be lent and borrowed. Therefore, in order to explain this theory, we must begin by considering loanable funds supply and demand.

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