Post on 21-Dec-2015
Interest Rates
• What are some major interest rates in financial markets? Be as specific as possible.
Nominal and Real Interest Rates
• Nominal return represents how much money you will receive after 1 year for giving up 1 dollar of money today
• Real return represents how many goods you can buy if you give up the opportunity to buy 1 good today.
• Nominal interest rate is money interest rate. Real interest rate is goods interest rate.
Real Interest Rate
• The real interest rate on the loan is defined as the future goods received relative to current goods foregone
11
$1 $11
$1
11
1
t+1t
t+1
t t
tt t t t
t
i iP 1r
PP P
ir r i
Ex Ante Rate and the Fisher Effect• Savings and investment decisions must be
made before future inflation is known so they must be made on the basis of an ex ante (predicted) real interest rate.
1EA FORECAST
t t ti r
Measuring the Real Interest Rate
• Long-term
1. Use the yield on inflation protected securities.
• Short-term
1. Use nominal interest minus consensus inflation forecast
2. Use nominal interest rate minus your own inflation forecast
TIPS Bond
• The US Treasury offers bonds whose principal and coupon payments increase with the inflation rate.
• Investors are paid off in terms of real purchasing power.
• Yield is equivalent to a real interest rate.
Additional Information from U.S. Treasury
Real & Nominal Interest Rates
π10 Year Forecast
http://research.stlouisfed.org/fred2/categories/22
Expected Inflation
• Surveys of professional forecasters might be one way of getting a good predictor of inflation.– For USA, available from Philadelphia Federal
Reserve Bank.– For other countries, available from Consensus
Forecasts. For a price!
1 1FORECAST SURVEYt t
Forecasts of Future Inflation
0
1
2
3
4
5
6
7
8
9
Se
p-8
1
Se
p-8
3
Se
p-8
5
Se
p-8
7
Se
p-8
9
Se
p-9
1
Se
p-9
3
Se
p-9
5
Se
p-9
7
Se
p-9
9
Se
p-0
1
Se
p-0
3
Se
p-0
5
Se
p-0
7
Se
p-0
9
%
1 Year Inflation 10 Year Inflation
Consensus Forecasts
Estimated Real Rates for USA
-6
-4
-2
0
2
4
6
8
10
1975 1980 1985 1990 1995 2000 2005
Real Interest Rate - Current InflationReal Interest Rate - Professional Forecast Inflation
•If a professional forecast is not available, we might want to use today’s inflation as a substitute.
1FORECASTt t
Loanable Funds Market• Consider the financial market at its broadest
and most abstract. – an amalgamation of the bond market and the
lending market (banks, etc.)
• Map the relationship between the interest rate and the quantity of funds that are lent.– Supply curve represents the behavior of savers &
lenders– Demand curve represents the behavior of
borrowers
Supply Curve: Loanable Funds
• Why does the supply curve slope up?– When real interest rates offered by banks are
high, savers are rewarded with more future consumption and are likely to be induced to save more.
– Caveat: If some savers are setting a target for their level of wealth at retirement, a higher interest rate reduces the amount they need to save. • For this reason, many economists believe saving
curve is very inelastic.
Demand Curve: Loanable Funds
• Why does the demand curve slope down?– Firms borrow to finance investment projects. If the
return on investment falls below the interest rate, the project is not worthwhile. The higher the interest rate, the fewer projects fall below the hurdle.
– Households borrow to finance housing. The higher are interest rates, the smaller is the house that the householders can buy with a mortgage payment that they can afford.
Globalization and the Loanable Funds Market
• Even ten years ago, we might have thought of the loanable funds market as being national in nature – especially for large economies. These days it appears that even the USA is part of a single global market. [China possible exception]
• Only very large changes in large countries or international trends will have an impact on real interest rates.
Ex. Investment Boom in Emerging Markets
McKinsey Report S
D
LF
r*
LF*
r
r**
D'
LF**
1
2
http://www.bea.gov/national/nipaweb/SelectTable.asp?Selected=Y
Savings
• We divide savings into 2 parts:
SPrivate Private Saving
(Household + Business Saving)
+SPublic Public Saving/Government Saving
(Budget Surplus)
= S National Saving
Public Savings is part of the supply of loanable funds if positive and part of demand for loanable funds if negative (as usual).
Ex.Japanese Government runs a deficitBudget Plan
D'
D
LF
r*
LF*
r
r**
S
LF**
1
2
National Economy
• How do national economies relate to the global financial market?
1. Countries will face an external interest rate, rW, unaffected by national savings or investment.
2. International capital flows will make up the gap between savings and investment.
Savings Glut
• Theory put forth by Fed Chairman explaining the U.S. trade deficit: Washington Post Article
Net Capital Outflows = ‘Goods & Income Outflows
• Private Savings: Y + NFI -Tax – C
• Public Savings: Tax – G
• National Savings: S = Y+ NFI – C – G
• Capital Outflows: -KA = S – I
S-I = NFI + (Y – C – G – I)= NFI +NX
http://www.bea.gov/national/nipaweb/SelectTable.asp?Selected=Y
US Current Account
-7.00%
-6.00%
-5.00%
-4.00%
-3.00%
-2.00%
-1.00%
0.00%
1.00%
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
NX NFI CA