Finance 381- Textbook Chapter 4

Alternative fisher equation

(1+i)=(1+r)(1+∆P(e)) i= r + ∆P(e)+(r∆P(e))

∆P(e)

= (P(t+1)-P(t)/P(e)

∆P(a)

= (p(t+1)-P(t))/p(t)

19.Explain what is meant by the term negative interest rate. Why can interest rate never be negative?

A negative interest rate on investment means that the investor (lender) pays the borrower rather than the other way around. Theoretically, interest rates cannot be negative because investors are better off not investing at all and earning zero percent interest than investing at negative interest rates.

16.Explain why it is important to adjust financial contracts for inflation. What is the relevant inflation factor?

It is important because investors want to realize a positive real rate of returns, in other words, to beat inflation. The relevant inflation factor is the average annual inflation rate anticipated over the period of investment.

Allocative Function

Like other prices, interest rates serve an _______ in our economy. They allocate funds between SSUs and DSUs among financial markets.

17.Explain when the market rate of interest is equal to the real rate of interest.

Since market rates are nominal rates, the market rate is equal to the real rate when inflation is zero during a period.

3.What is the "Fisher effect"? How does it affect the nominal rate of interest?

The Fisher effect, espoused by Irving Fisher, theorizes that expected inflation is embodied in current nominal interest rates. Assuming the ability to forecast expected inflation, nominal rates should vary directly with expected inflation.

Realized real rate of return

can be defined as the actual rate of return to the lender at the conclusion of the loan contract

APR

e(1)/e(0)=[1+(i(U.S.)/m)]

Approximate Fisher Equation

i = r + ∆P(e) Is named after economist Irving Fisher

i = r + ∆P(e)

i= nominal rate of interest (contract rate) r = real rate of interest ∆P(e)= expected annualized Price Level Change

7.What is the track record of professional interest forecasters? What do you think explains their performance?

Accurate forecasters will not likely publish their forecasts, but will use their ability to extract profits from the markets. This adjustment process, which incorporates all available information in an efficient market will adjust the current rate structure to reflect the consensus forecast. Studies of public forecasts indicate a very poor forecasting ability.

Positive Time Preference

All things being equal people prefer to consume goods today rather than tomorrow. this is called a _____

2.If the money supply is increased, what happens to the level of interest rates?

An increase in the money supply shifts the supply of loanable funds to the right, lowering interest rates.

20.In financial markets, we occasionally observe negative interest rates. Reconcile the contradiction between the statement "The nominal rate of interest will never decline below zero" with the negative interest rate that occurred in the Japanese Treasury bill market in November 1998.

In some situations, investors seek safe storage for their money. In November 1998 in Japan many large investors did not want to keep money at banks, as they worried about the banking system's health, and preferred to store the money in government bills; the overwhelming demand for the bills, coupled with an already very low interest rate environment, drove the T-bill yields below zero. The desire to preserve capital trumped the desire to grow it.

14.Explain how the market rate of interest is determined applying the loanable fund interest rate model.

Interest rates depend on the supply of and demand for funds, which in turn depend on thrift and productivity. The sources of supply of loanable funds are consumer and business savings, government budget surpluses, and Federal Reserve increases in the money supply. The sources of demand are consumer credit purchases, business investments, and government budget deficits, and Federal Reserve decreases in money supply.

12.Explain what is meant by the term positive time preference for consumption. How does it affect the rate of interest?

Most people prefer to consume goods sooner rather than later. This is known as a positive time preference for consumption. The higher this time preference is, the higher interest rate a person should be offered to forgo consumption and make an investment.

11.Explain what the nominal rate of interest is and how it is related to the real rate of interest.

Nominal rates are the quoted interest rates we observe in the marketplace. A nominal rate includes the real rate plus expected inflation over the investment period.

Real Rate of Interest

One of the most important economic variables in the economy. It is the rate of interest determined by the returns earned on investments in productive assets in the economy and by individuals' time preference for consumption

6.Under what conditions is the loss of purchasing power on interest in the Fisher effect an important consideration?

Retired individuals or foundations with fixed interest rate returns on long-term CD or bond investment portfolios are hurt with actual or anticipated inflation. With expected inflation, market interest rates increase, and the value of the investment declines. With inflation and fixed interest income, less can be purchased each period.

10.If the realized real rate of return turns out to be positive, would you rather have been a borrower or a lender? Explain in terms of the purchasing power of the money used to repay a loan?

The answer depends upon whether the lender (borrower) earns (pays) their expected real rate on the loan? If inflation were originally underestimated, borrowers would benefit at the cost of the lender for their realized real cost of borrowing would be less. If inflation were overestimated the lender would benefit at the cost of borrower for realized real returns (borrowing costs) would higher than originally anticipated. If a 3% real return (cost) were the agreed upon at the beginning of a $1000, one-year loan, and inflation expectations were 4%, lender and borrower would have been satisfied at the beginning of the loan with a 7% nominal rate. If inflation realized is 5%, the lender (borrower) only earns (pays) 2%. If realized inflation is 3%, the lender (borrower) real return (cost) is 4%.

13.Explain how the equilibrium real rate of interest is determined.

The equilibrium rate of interest is the point where the desired level of borrowing by deficit spending units (DSUs) equals the desired level of lending by surplus spending units (SSUs).

Nominal Rate of interest

The interest rate we observe in the marketplace at any given time

1.What factors determine the real rate of interest?

The real rate of interest is determined by: (a) individual time preference for consumption, and (b) the return that firms expect to earn on their real capital investments. In equilibrium, the real rate of interest is determined when desired saving equals desired investment.

18.Explain what is meant by the realized rate of return. How does it differ from the real rate of interest?

The realized rate of return is the actual real rate to the lender at the conclusion of the loan contract. It depends on the actual inflation during the period. The real rate of interest is the base interest rate for the economy and is closely related to the productivity of capital investments and the people's time preference for consumption.

Interest Rate

The rental price of money

15.What is the value of money? How does the value of money vary with aggregate price-level changes?

The value of money is its purchasing power, or goods and services that can be bought with it. Price increases (decreases) decrease (increase) the value of money because a dollar can buy less (more).

8.Explain how forecasters using the flow-of-funds approach determine future interest rate movements.

Using the loanable funds theory, forecasters predict funds flow through sectors looking for significant supply/demand variations, which may signal changes in interest rates.

Return on investment

Usually measured as a percentage. It is the output generated by a capital project

r(r) ≈ i - ∆P(a)

r(r)= realized real rate of return on a loan contract i= observed nominal rate of interest ∆P(a)= actual rate of inflation during the loan contract