Topic 9: Interest Rates

Question 1

What is an inflation premium?

Answer 1

The extra interest an investor will demand if they expect inflation over the course of a loan.

Question 2

What is the real interest rate?

Answer 2

r = i - π^e

Question 3

Explain the reasoning behind the taylor rule.

Answer 3

John Taylor suggested that the nominal interest rate should be set with regard to:

• The rate of inflation.
• The target rate of inflation.
• Output (real income).
• Natural output.
• The equilibrium real rate of interest.

Question 4

Show the full form of the taylor rule.

Answer 4

Question 5

Show the reduced form of the taylor rule.

Answer 5

i = π + 1/2(π - 2) + 1/2(g-g*) + 2.

Question 6

When should the taylor rule be used?

Answer 6

In relatively stable equilibrium cases. Not during financial crisis.

Question 7

What are some limitations of the Taylor rule?

Answer 7

• Measuring target inflation and target output can be problematic. (CB can have different goals to Gov.)
• Lags in monetary transmission processes are secondary.
• Forward expecations may be underweighted.
• For open economies, the effect of the exchagne rate change is ignored.

Question 8

Show the fisher equation

Answer 8

i = r +π*

where now π* = expected inflation rate.

Question 9

Show on a graph how the interest rate might change given an expansions in the money supply.

Answer 9

The inial lowering is due to the liquidity effect, and is Keynesian in nature.

The second effect occurs due to the fisher rule.

Question 10

How is the interest rate determined in an open economy?

Answer 10

• Under a fixed regime it must be very close to the international interest rate.
• But in a flexable system exchange rates can allow different rates of inflation, and so different levels of nominal interest rates.

Question 11

What is the international fisher effect?

Answer 11

That:

i.e.

r^e_A = r^e_US

Question 12

What is the fisher open hypothesis?

Answer 12

States that the %difference in interest rates is equal to the expected change in the spot rate.

Question 13

What is the international fisher effect and the fisher open hypothesis contingent on?

Answer 13

Purchasing power parity, such that:

Question 14

Show the international fisher effect, the fisher open hypthesis and relative PPP thoery all together.

Answer 14

The first two equations fail without the third.

Question 15

What is expectations theory?

Answer 15

Also known as forward market efficiency.

f₀ = s_t^e

Question 16

Show the CIP equation in this course.

Answer 16

Question 17

Derive CIP from the other models in this course.

Answer 17

Question 18

What is the equation that reconciles interest rates for bonds of different structures?

Answer 18

(1+i₂)² = (1+i₁)(1+i*)

Where i₁ = interest rate on one year bond.

i₂ = interest rate on two year bond.

i* expected one year interest rate in year two.

Question 19

If expectations of interest rates are unbiased, what would the long term interest rate of a loan over n short period be?

Answer 19

1+ R = (1+r₁)(1+r₂)…(1+r_n)^1/n

Question 20

What does liquidity preference suggest about yield curves?

Answer 20

• Short terms loans are more liquid.
• The interest is the price of forgone liquidity.
• So long term loans should have a higher interest rate. (The difference being the liquidity premium.)
• The liquidity premium for McClelland is the reduction in interest rate allowed due to extra liquidity, not the other way around.

Question 21

What does a downward sloping yield curve mean?

Answer 21

That interest rates are expected to fall.