FINC412 chapter 2 HW

Impact of Government Spending. Jayhawk Forecasting Services analyzed several factors that could affect interest rates in the future. Most factors were expected to place downward pressure on interest rates. Jayhawk also expected that although the annual budget deficit was to be cut by 40 percent from the previous year, it would still be very large. Thus, Jayhawk believed that the deficit's impact would more than offset the effects of other factors, so it forecast interest rates to increase by 2 percent. Comment on Jayhawk's logic.

A reduction in the deficit should free up some funds that had been used to support the government borrowings. Thus, there should be additional funds available to satisfy other borrowing needs. Given this situation plus the other information, Jayhawk should have forecasted lower interest rates.

Impact of Government Spending. If the federal government planned to expand the space program, how might this affect interest rates?

An expanded space program would (a) force the federal government to increase its budget deficit, (b) possibly force any firms involved in facilitating the program to borrow more funds. Consequently, there is a greater demand for loanable funds. The additional spending could cause higher income and additional saving. Yet, this impact is not likely to be as great. The likely overall impact would therefore be upward pressure on interest rates.

Impact of Exchange Rates on Interest Rates. Assume that if the U.S. dollar strengthens, it can place downward pressure on U.S. inflation. Based on this information, how might expectations of a strong dollar affect the demand for loanable funds in the United States and U.S. interest rates? Is there any reason to think that expectations of a strong dollar could also affect the supply of loanable funds? Explain.

As a strong U.S. dollar dampens U.S. inflation, it can reduce the demand for loanable funds, and therefore reduce interest rates. The expectations of a strong dollar could also increase the supply of funds because it may encourage saving (there is less concern to purchase goods before prices rise when inflationary expectations are reduced). In addition, foreign investors may invest more funds in the United States if they expect the dollar to strengthen, because that could increase their return on investment.

Impact of a Recession. Explain why interest rates tend to decrease during recessionary periods. Review historical interest rates to determine how they react to recessionary periods. Explain this reaction.

During a recession, firms and consumers reduce their amount of borrowing. The demand for loanable funds decreases and interest rates decrease as a result.

Impact of War. A war tends to cause significant reactions in financial markets. Why would a war in Iraq place upward pressure on U.S. interest rates? Why might some investors expect a war like this to place downward pressure on U.S. interest rates?

A war in Iraq places upward pressure on U.S. interest rates because it (1) increased inflationary expectations in the United States as oil prices increased abruptly, and (2) increased the expected U.S. budget deficit as government expenditures were necessary to boost military support. However, it may also cause some analysts to revise their forecasts of economic growth downward. The slower economy reflects a reduced corporate demand for funds, which by itself places downward pressure on interest rates. If inflation was not a concern, the Fed may attempt to increase money supply growth to stimulate the economy. However, the inflationary pressure can restrict the Fed from increasing the money supply to stimulate the economy (since any stimulative policy could cause higher inflation).

Real Interest Rate. Estimate the real interest rate over the last year. If financial market participants overestimate inflation in a particular period, will real interest rates be relatively high or low? Explain.

If inflation is overestimated, the real interest rate will be relatively high. Investors had required a relatively high nominal interest rate because they expected inflation to be high (according to the Fisher effect).

Impact of the Money Supply. Should increasing money supply growth place upward or downward pressure on interest rates?

If one believes that higher money supply growth will not cause inflationary expectations, the additional supply of funds places downward pressure on interest rates. However, if one believes that inflation expectations do erupt as a result, demand for loanable funds will also increase, and interest rates could increase (if the increase in demand more than offsets the increase in supply).

Interest Rate Movements. Explain why interest rates changed as they did over the past year.

The Loanable Funds Theory suggests that the market interest rate is determined by the factors that control supply of and demand for loanable funds. There is an inverse relationship between the interest rate and the quantity of loanable funds demanded.

Impact of the Economy. Explain how the expected interest rate in one year depends on your expectation of economic growth and inflation.

The interest rate in the future should increase if economic growth and inflation are expected to rise, or decrease if economic growth and inflation are expected to decline.

Impact of Expected Inflation. How might expectations of higher global oil prices affect the demand for loanable funds, the supply of loanable funds, and interest rates in the United States? Will this affect the interest rates of other countries in the same way? Explain.

The expectations of higher oil prices will cause concern about the possible increase in inflation. Since higher inflation can increase interest rates, it will cause an expectation of higher interest rates in the U.S. Firms and government agencies may borrow more funds now before prices increase and before interest rates increase. Consumers may use their savings now to buy products before the prices increase. Therefore, the demand for loanable funds should increase, the supply of loanable funds should decrease, and interest rates should increase in the U.S. -The impact of higher global oil prices in other countries is not necessarily the same. If the country produces its own oil, it can set the oil prices in its country. If it can prevent high oil prices in its country, then the prices of products (gasoline) and services (transportation) may not be affected. Therefore, interest rates may not be affected.

Nominal versus Real Interest Rate. What is the difference between the nominal interest rate and real interest rate? What is the logic behind the implied positive relationship between expected inflation and nominal interest rates?

The nominal interest rate is the quoted interest rate, while the real interest rate is defined as the nominal interest rate minus the expected rate of inflation. The real interest rate represents the recent nominal interest rate minus the recent inflation rate. -Investors require a positive real return, which suggests that they will only invest funds if the nominal interest rate is expected to exceed inflation. In this way, the purchasing power of invested funds increases over time. As inflation rises, nominal interest rates should rise as well since investors would require a nominal return that exceeds the inflation rate.

Impact of September 11. Offer an argument for why the terrorist attack on the United States on September 11, 2001 could have placed downward pressure on U.S. interest rates. Offer an argument for why that attack could have placed upward pressure on U.S. interest rates.

The terrorist attack could cause a reduction in spending related to travel (airlines, hotels), and would also reduce the expansion by those types of firms. This reflects a decline in the demand for loanable funds, and places downward pressure on interest rates. Conversely, the attack increases the amount of government borrowing needed to support a war, and therefore places upward pressure on interest rates.

Interest Elasticity. Explain what is meant by interest elasticity. Would you expect federal government demand for loanable funds to be more or less interest-elastic than household demand for loanable funds? Why?

Interest elasticity of supply represents a change in the quantity of loanable funds supplied in response to a change in interest rates. Interest elasticity of demand represents a change in the quantity of loanable funds demanded in response to a change in interest rates. -The federal government demand for loanable funds should be less interest elastic than the consumer demand for loanable funds, because the government's planned borrowings will likely occur regardless of the interest rate. Conversely, the quantity of loanable funds by consumers is more responsive to the interest rate level.

Global Interaction of Interest Rates. Why might you expect interest rate movements of various industrialized countries to be more highly correlated in recent years than in earlier years?

Interest rates among countries are expected to be more highly correlated in recent years because financial markets are more geographically integrated. More international financial flows will occur to capitalize on higher interest rates in foreign countries, which affects the supply and demand conditions in each market. As funds leave a country with low interest rates, this places upward pressure on that country's interest rates. The international flow of funds caused this type of reaction.

Forecasting Interest Rates. Why do forecasts of interest rates differ among experts?

Various factors may influence interest rates, and changes in these factors will affect interest rate movements. Experts disagree about how various factors will change. They also disagree about the specific influence these factors have on interest rates.

Impact of Stock Market Crises. During periods when investors suddenly become fearful that stocks are overvalued, they dump their stocks, and the stock market experiences a major decline. During these periods, interest rates also tend to decline. Use the loanable funds framework discussed in this chapter to explain how the massive selling of stocks leads to lower interest rates.

When investors shift funds out of stocks, they move it into money market securities, causing an increase in the supply of loanable funds, and lower interest rates.