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ECON313 > Chapter 6- Interest Rates > Flashcards

Chapter 6- Interest Rates Flashcards

1
Q

Define the term “interest rates”.

A

The remuneration received by entities who sacrifice some consumption of goods and services today instead of saving part of their income for future consumption. It is also the cost of borrowed funds for those entities who want to consume more goods and services than allowed by their current income.

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2
Q

Define the rate of Interest

A

The cost of this borrowing divided by the amount of money borrowed usually expressed on an annual percentage basis.

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3
Q

What are Short-term and Long-term interest rate?

A

-Interest rates on financial instruments with a lifespan of less than 1 year( traded on money markets- highly liquid).
-Interest rates on securities with maturity periods of one year or longer(traded on capital markets).

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4
Q

How does inflation relate to interest rates?

A

-Inflation has a powerful bearing on interest rates, lending, and borrowing decisions.
-Lenders lend at a rate that does not erode their purchasing power.
-Borrowers will only borrow at a high-interest rate if they expect their income to be adjusted.

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5
Q

Define Nominal Interest Rate.

A

The quoted interest rate on financial assets.

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6
Q

Define Real interest Rate.

A

The return to lender or investor in terms of purchasing power. (= Nominal interest rate - expected inflation rate)

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7
Q

State Fischer Effect and argument.

A

-Fisher argued that expected inflation is likely to be reflected in expected nominal interest rates over the short term.
-Because the real interest rate depends on long run factors such as :
Productivity of capital
The volume of savings
-Which are all likely to change significantly over the short term.
-Fisher effect therefore says an increase inflation rate should lead to higher inflation expectations and an increase in nominal interest rates.

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8
Q

Hypothesis example for Fischer’s effect.

A

With a real interest rate of 2%, a nominal interest of 6%, and an increase in the expected inflation rate from 4%-5%. The nominal interest rate will increase to 7% and the real interest rate will remain unchanged.

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9
Q

What was Keynesian’s argument in contrast to Fischer’s ?

A
  • Argued that inflation would affect real interest rates rather than nominal interest rate.
  • The nominal interest rate is determined by the demand or supply of money.
  • Inflation expectations have no effect on expected nominal interest rates unless money demand or supply is affected.
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10
Q

What are the weaknesses of the Fischer effect?

A

-Has been criticized on its assumption that inflation is fully anticipated
- If a portion of the increase in inflation is unanticipated , the nominal interest rate may not fully reflect the expected inflation rate.
- Disagreements on how expected inflation rate should be measured
- Needs to take into account an inflation-related risk premium for the lender to represent the unexpected inflation
- Difficult to accurately forecast long-term inflation than short-term inflation

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11
Q

Hypothesis example according to Keyneshians:

A

Thus with a real interest rate of 2%, and expected inflation rate of 6% and a risk premium of 1% for unanticipated inflation, the nominal interest rate should be 9%.

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12
Q

What is Knut Wickshell’s argument?

A

-inflation depends on the deviation of interest rates away from their natural rate
- Monetary Policy influenced the economy largely through interest rates.
- Based on this approach: the Demand for money is a function of both income and interest rates.
- Changes in money stock are used to raise or lower interest rates.
Hence the development of the term ”natural interest rates”

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13
Q

State Wickshell’s view on the average interest rate and the natural rate.

A
  • If average interest rate is set below the natural level, prices will rise and continue to rise
  • inflation will resultantly accelerate.
  • Conversely, if the average rate of interest is above the current level of the natural rate, prices will fall continuously without a limit.
  • Many central banks, including SARB do acknowledge the existence of natural rate.
  • Difficult to determine the natural rate in practice
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14
Q

Apart from expected inflation, what determines interest rates?

A

Apart from expected inflation, economists now generally agree that the supply of and demand for loanable funds determine interest rates. Supply of funds is dependent on domestic savings

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15
Q

List the determination of interest rates theories.

A

-Monetary policy
-Interest rates theory
-Interest rates in the bond market

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16
Q

Monetary policy: what is the main monetary policy operational variable for many countries?

A

Rate used by central banks to provide funds to banks and manage liquidity. This rate is the bank’s official interest rate (repo rate in our case).

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17
Q

What happens when the central bank changes its official rate?

A

short-term domestic interest rates and sometimes long-term interest rates also change in the same direction and by similar amounts. Changes in this rate sometimes creates inflation expectations

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18
Q

List the sub theories under the interest rate theory.

A
  • Classical theory
  • liquidity preference theory
  • Loanable funds theory
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19
Q

According to the classical theory, how are interest rates determined?

A

By supply of savings (households) and demand for investments (businesses)

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20
Q

How is the equilibrium rate of interest determined according to the classical theory?

A

where quantity of savings supplied to market = quantity of funds demanded for investment.

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21
Q

What are the criticisms of the classical theory?

A

-Ignores short-term factors such as the volume of money being created and destroyed.
-Ridiculous assumptions on source of savings (in most cases, households are net borrowers)

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22
Q

According to Liquidity preference theory, how are interest rates determined?

A

Interest rates are determined by demand for and supply of money

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23
Q

What is the demand of money according to the liquidity preference theory?

A

The public demand to undertake transactions as a precaution against uncertainties, and also for speculative purposes arising from price changes.

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24
Q

How is the equilibrium rate of interest determined according to Liquidity preference theory?

A

Where the total demand of money= total supply of money

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25
Q

What are the criticisms of the liquidity preference theory?

A

-Theory is limited and does not take other factors (e.g. inflationary expectations) which may have an impact on interest rates.
- It is only a short-term approach to interest rates
- It ignores the impact of the demand for credit on the cost of credit

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26
Q

According to the Loanable funds theory , how are interest rates determined?

A

Nominal interest rate is determined by the Supply of & Demand for credit (loanable funds)

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27
Q

How is the equilibrium rate of interest determined according to the loanable funds theory?

A

Supply of loanable funds = Demand for loanable funds

28
Q

Which theory overcame most shortcomings of the Classical and liquidity prefrence theories?

A

Loanable funds theory

29
Q

What factors affect the supply of loanable funds?

A
  • Domestic Savings
  • Hoarding
  • Credit creation
  • International financial flows
30
Q

What affects domestic savings?

A

Household size, personal income, accumulated wealth, income expectations, job security, age, social security,

31
Q

State the substitution effect of interest rates and savings.

A
  • Indicates that there should be a positive relationship between interest rates and savings.
  • Higher interest rates (r) raise the attractiveness of saving (s) compared to consumption (C)
32
Q

State the income effect of interest rates and savings.

A
  • For savers = Higher r should lead to higher income (Y) allowing them to increase their C at the cost of s
  • For borrowers = An increase in r will increase the cost of borrowing, which will reduce C and increase s
33
Q

State the Wealth effect of interest rates and savings.

A

-If r increase, the market value of many financial assets will fall, forcing higher s to protect wealth positions
-If r decrease, the market value of many financial assets will increase, increasing wealth and lowering s

34
Q

What is hoarding?

A

Difference between the public’s demand for and the supply of money.

35
Q

how does hoarding affect loanable funds?

A

During excess demand for credit: hoarding reduces volume of loanable funds, for example, money kept under mattresses reduce loanable funds.

36
Q

When does dishoarding occur?

A

When the demand for money is less than the supply of money. Some entities will dispose the excess cash holdings(e.g. spending), this will increase the supply of loanable funds.

37
Q

How does credit creation affect loanable funds?

A

-via the central bank through measures aimed at increasing liquidity in the domestic market.
-via banks through investing and lending cash reserves to consumers
- A reduction in the amount of credit extended by banks leads to a reduction in loanable funds.

38
Q

How do international financial flows affect the supply of loanable flows?

A

-Lending and borrowing is sensitive to differences between foreign and domestic interest rates.
- Investing a part of savings in other countries will reduce supply of loanable funds in own country
- Flows from non-residents will increase supply of loanable funds

39
Q

What does the demand for loanable funds consist of?

A

demand of credit by:
Household
Business enterprises
Government
Borrowing of non-residents

40
Q

Why are loanable funds demanded by Households and what factors affect this demand ?

A
  • For consumption
  • the demand for credit is affected by many factors such as current income, expected future income, job security, level of wealth, inflation expectations
41
Q

Why are loanable funds demanded by Business enterprises and what factors affect this demand ?

A
  • For consumption
    -Depends mostly on profit expectations, inflation expectations, risk, return on capital
42
Q

What factors influence the demand for loanable funds by the Government?

A

Dependent on the type of fiscal policy followed and on government policies for expenditure and taxation. Governments usually borrow more during recession than blooming periods.

43
Q

What factors influence the demand for loanable funds by non residents?

A

Depends on interest rate differential between two countries and expected exchange rate movements. For example, a resident in Botswana would borrow from SA at a lower interest rate, provided that the rand doesn’t appreciate.

44
Q

How do interest rates affect the demand for loanable funds?

A

-Higher interest rates = reduced demand for loanable funds.
- Higher interest rates = reduction in investments and credit demand of businesses.
The opposite applies!
-

45
Q

What is the equilibrium rate of interest?

A

The point where the supply of loanable funds is equal to the demand of loanable funds.( Depicted by figure 6.2)

46
Q

How is the interaction between supply and demand for loanable funds illustrated?

A

The Interaction between S & D for loanable funds can be illustrated with an analysis of the bond market.

47
Q

What is the assumption of the bond market analysis?

A

All factors except bond price do not change.

48
Q

What does the bond demand curve depict?

A
  • The relationship between the price and the quantity of bonds demanded by investors(depicted by figure 6.3).
  • The lower the price, the higher the demand for the bond.
49
Q

What does the bond supply curve depict?

A
  • The relationship between the price and the quantity of bonds willing to be sold.
  • The higher the price, the higher the supply because more funds can be raised by selling them
50
Q

How can the supply and demand of bonds be regarded as?

A

-The Supply of bonds = D for funds by Firms & Gov.
-The Demand for bonds = S of funds by investors

51
Q

What the two types of bonds sold in this context?

A
  • Corporate bonds by large companies
  • Government bonds by the government
52
Q

How do government bonds work?

A

-When you buy a government bond, you lend the government an agreed amount of money for an agreed period of time.
-In return, the government will pay you back a set level of interest at regular periods, known as the coupon.
-This makes bonds a fixed-income asset.
-Once the bond expires (matures), you’ll get back to your original investment

53
Q

Which factors will influence the Supply of bonds?

A

-Business conditions
-Expected inflation
-Government borrowing

54
Q

How do business conditions influence the supply of bonds?

A

During periods of strong economic growth, there’s many productive investments that business can take. Many businesses see investment opportunities. They will also be willing to borrow money therefore issuing bonds. Thus, causing an increase in the supply of bonds

55
Q

How does expected inflation influence the supply of bonds?

A

Payout from bonds are fixed or taken over long term. They just don’t adjust to inflation. So higher inflation enables borrowers of funds to repay their debts (being the bond) with cash that is now worth less. Reducing the supply of bonds

56
Q

How does government borrowing influence the supply of bonds?

A

-Government is the biggest player in the bond market. So, bonds are essentially government borrowing from investors to spend on infrastructure , education.
-So greater government borrowing needs=increase in supply of gov bonds

57
Q

Which factors will influence the Demand of bonds?

A
  • Wealth
  • expected returns
  • risk
58
Q

How does wealth influence the demand of bonds?

A

Increase in wealth means that individuals have surplus funds that they can invest/spend. So, there will be an increase in the demand for bonds

59
Q

How do expected returns influence the demand of bonds?

A

If you expect an increased return on a bond, this means that more people will want to purchase the bond. This will then increase the demand for the bond

60
Q

How does risk influence the demand of bonds?

A

The riskier the bond, the less demand there is for the bond. Uncertainty regarding a bond payout will lead to a decrease in the demand for the bond

61
Q

What are the some of the most important interest rates in SA?

A
  • Repo rate, also know as accommodation rate
  • Prime overdraft rate
62
Q

Define prime overdraft rate.

A

Rate at which banks lend money to their clients on overdraft.

63
Q

Define term spread.

A

The difference between the long and the short end if the yield curve, or the difference between the yields on government securities with a maturity of 10 years and longer and those with outstanding term of three years and shorter.

64
Q

What does large term spread imply?

A

That long term yields are much higher than short term yields.

65
Q

What does negative term spread imply?

A

That long term yields are lower than short term yields.

ECON313 (6 decks)

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