What determines interest rate? Flashcards
what is Loanable funds theory ?
- real interest rates are determined by the supply and demand for loans
- The theory assumes only one type of loan and one interest rate; it ignores the diversity of rates illustrated
- The theory also assumes that savers lend directly to investors, which ignores the role of bank
what is Capital inflows?
- funds provided to a country’s investors by foreigners
what is Capital outflows ?
- Funds provided to foreign investors by a country’s savers
Net capital inflows :
capital inflows minus capital outflows
Private saving :
- saving by individuals and firms
Public saving :
- saving by the government (tax revenue minus government spending)
Budget surplus :
- a positive level of public saving
Budget deficit :
- a negative level of public saving
what affects have a higher real interest rate in the demand for loans ?
- A higher real interest rate makes investment more costly, so fewer projects are undertaken. Lower investment means that investors want fewer loans.
Effects on the supply of loans, if the interest rate increase:
- higher returns to saver
- higher interest rate encourages people to save more
- decreases capital outflows.
the equilibrium real interest rate, r*:
- it is the interest rate at which the supply and demand curves intersect.
what happens when there is an excess of supply of loans?
- it means that the interest rate is higher than the equilibrium
- Not all lenders can find borrowers
- In this situation, lenders should offer lower interest rates to attract borrowers, pushing rates down
what happens when there is an excess of demand for loans?
- it means that the interest rate is lower than the equilibrium
- not all borrowers can find lenders
- borrowers offer higher rates to attract lenders, pushing rates up
Meaning of Budget surplus:
- a positive level of public saving
Meaning of Budget deficit:
- a negative level of public saving
what is Capital Flight ?
- sudden decrease in net capital inflows that occurs when foreign savers lose confidence in an economy
Two categories of saving :
- Private Saving
- Public Saving
Why might capital flows shift?
- Changes in Confidence
- Foreign Interest Rates
How Foreign Interest Rates affected local interest rate ?
- interest rates in different countries are connected
- they tend to move in the same direction An event that raises the interest rate in one country, such as a higher budget deficit, reduces net capital inflows to other countries. The supply of loans falls in the other countries, so their interest rates rise too.
Fisher equation : (formula)
- the nominal interest rate equals the real rate plus expected inflation:
I= r + pie
- “r” is the real interest rate
- “i” is the nominal rate
- “pie” is expected inflation
Theory of Adaptive expectations: definition and formula
- theory that people’s expectations of a variable are based on past levels of the variable; also, backward looking expectations.
pie = pi-1
- “pie“ mean expected inflation
- “pi-1“ mean inflation of the last year
Liquidity preference theory:
- the nominal interest rate is determined by the supply and demand for money
the key simplifying assumption that only two kinds of assets exist: (liquidity preference theory)
- Money
the medium of exchange
People use money to purchase goods and services
they can’t use bonds.
- Bonds
It pay interest but money does not
what is money supply ?
The money supply is the total amount of money in the economy.
what is money demand ?
Money demand is the amount of wealth that people choose to hold in the form of money.
The equilibrium interest rate :
-Money demand and Money supply
Liquidity Preference Theory: Factors That Can Change the Nominal Interest Rate
- -Shifts in Money Supply
- Decisions by the central bank
- -Shifts in Money Demand
- Changes in aggregate spending
- Changes in transaction technologies
Nominal GDP formula: (total spending)
- An economy’s total spending:
nominal GDP = real GDP x aggregate price level
Increase in nominal GDP (aggregate spending)
- Rise in real GDP (economic growth)
- Rise in the price level (inflation).
- In either case, higher spending shifts money demand to the right, raising the equilibrium interest rate
transaction technologies effects in Nominal GDP
- the methods that people use to obtain money and spend it.
- Transaction technologies evolve over time, changing the amount of money that people wish to hold.
Factors That Explain Differences Among Interest Rates
- Maturity (term)
- Default risk
- Liquidity
- Taxation
what is “Term structure of interest rates”?
- Relationships among interest rates on bonds with different maturities
Expectations theory of the term structure
- the “n” period interest rate is the average of the current one-period rate and expected rates over the next n - 1 periods
Expectations Theory of the term structure (formula)
in(t) = 1/n . [i1 (t) + Ei1 . (t + 1) + … + Ei1 . (t + n - 1)]
- E means “expected.”
- “in(t)” be the interest rate on an n-period bond in period t
- “n” stand for maturity
- “t” stand for term (period of loan - the year)
what is Term premium (t) ?
- It is a extra return on a long-term bond that compensates for its riskiness;
- tn denotes the term premium on an “n” period bond
The Expectation Theory with a Term Premium (formula)
in(t) = 1/n . [i1 (t) + Ei1 (t + 1) +. . .+ Ei1 (t + n - 1)] + r
- “E” means“expected.”
- “in(t)”be theinterest rateon an n-period bond in period t
- “n” stand for maturity
- “t” stand for term (period of loan - the year)
- “r” stand for Premiun
what is the meaing of “Yield curve” ?
- it is a progressive line in a graph that compare interest rates on bonds of various maturities at a given point in time
Equation Yields: formula
in (t) = i1 (t) + rn
- “in(t)” be the interest rate on an “n” period bond in period t
- “n” stand for maturity in year
- “t” stand for term (period of loan - the year)
- “r” stand for Premiun
Inverted yield curve:
- downward-sloping yield curve signifying that short- term interest rates exceed long-term rates
How is posible to forecast Interest Rates ?
- The expected path of interest rates determines the shape of the yield curve
- the yield curve tells us about the expected path of rates
- so the inverse of the yield help to forecast the interest rate.
Sovereign debt:
- bonds issued by national governments
what are the Bond-rating agencies?
- firms that estimate default risk on bonds
- Rating agencies summarize their judgments with a grade for each coun- try’s debt.
For example, Standard & Poor’s gives ratings from AAA (triple A, the highest) to D (the lowest).
- Sometimes a plus or minus is added to the letter grade
Sovereign Debt Ratings: (example 2010)
what is consider junk bond ?
- corporate bond with an S&P rating below BBB
what is “High-yield spread:”?
- difference between interest rates on BBB and AAA corporate bonds with 10-year maturities
Municipal bonds:
bonds issued by state and local governments
