Financial Institutions and Markets INTEREST RATES Nominal and

Nominal and Real Interest Rates §Nominal interest rate includes inflation §Real interest rate is

Loanable Funds Theory §Supply: household savings and corporate earnings §Demand: consumer spending and business

Loanable Funds and Nominal Interest Rates §Inflation expectation leads to cash reserves §Cash reserves

International Interest Rates §Rich countries: high supply = low rates §Poor countries: low supply

Liquidity Preference Theory §Liquid assets less risky than illiquid assets §Interest rate increases =

Monetary Authorities and Interest Rates §Central bank adjusts discount rate to influence market rates;

Banks, Interest Rates, and Strategy §Do banks lower rates when loan demand shifts downward?

Term Structure of Interest Rates §Yield curve: relationship between interest rates and time to

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Financial Institutions and Markets INTEREST RATES

Nominal and Real Interest Rates §Nominal interest rate includes inflation §Real interest rate is adjusted for inflation §Real interest rate = nominal rate – inflation rate If the nominal rate on an investment is 8% and inflation is 5%, what is the real interest rate? 8% - 5% = 3% real interest rate

Loanable Funds Theory §Supply: household savings and corporate earnings §Demand: consumer spending and business investment §Supply/demand equilibrium leads to market interest rate §Real rates change slowly §Understates the role of monetary authorities

Loanable Funds and Nominal Interest Rates §Inflation expectation leads to cash reserves §Cash reserves = increased money supply §Increased money supply = prices increase §Price increases = borrow more for same purchases §New equilibrium: nominal rate > real rate

International Interest Rates §Rich countries: high supply = low rates §Poor countries: low supply = high rates §Why don’t funds move from rich to poor? §Exchange rate risk §Default risk §Political risk §Capital outflow from poor to rich countries

Liquidity Preference Theory §Liquid assets less risky than illiquid assets §Interest rate increases = loss in asset value §Response to interest rate expectations §Expected increase: sell assets §Expected decrease: buy assets §Real rates can change quickly §Emphasizes the role of monetary authorities

Monetary Authorities and Interest Rates §Central bank adjusts discount rate to influence market rates; however… §Large banks have market power and sometimes act independently of the central bank

Banks, Interest Rates, and Strategy §Do banks lower rates when loan demand shifts downward? Or do they just lend less money? §Do banks lend to everybody at the market rate? Or do they only lend to the best borrowers?

Term Structure of Interest Rates §Yield curve: relationship between interest rates and time to maturity §Factors §Future anticipated interest rates §Preference for liquidity (=shorter term investments) §Likelihood of inflation