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Unformatted text preview: Chapter 6: Interest Rates Learning Objectives 117 Chapter 6 Interest Rates Learning Objectives After reading this chapter, students should be able to: Explain how capital is allocated in a supply/demand framework, and list the fundamental factors that affect the cost of money. Write out two equations for the nominal, or quoted, interest rate, and briefly discuss each component. Define what is meant by the term structure of interest rates, and graph a yield curve for a given set of data. Explain what factors determine the shape of the yield curve. Use the yield curve and the information embedded in it to estimate the markets expectations regarding future inflation and risk. List four additional factors that influence the level of interest rates and the slope of the yield curve. Discuss country risk. Briefly explain how interest rate levels affect business decisions. 118 Integrated Case Chapter 6: Interest Rates Answers to End-of-Chapter Questions 6-1 Regional mortgage rate differentials do exist, depending on supply/demand conditions in the different regions. However, relatively high rates in one region would attract capital from other regions, and the end result would be a differential that was just sufficient to cover the costs of effecting the transfer (perhaps of one percentage point). Differentials are more likely in the residential mortgage market than the business loan market, and not at all likely for the large, nationwide firms, which will do their borrowing in the lowest-cost money centers and thereby quickly equalize rates for large corporate loans. Interest rates are more competitive, making it easier for small borrowers, and borrowers in rural areas, to obtain lower cost loans. 6-2 Short-term interest rates are more volatile because (1) the Fed operates mainly in the short-term sector, hence Federal Reserve intervention has its major effect here, and (2) long-term interest rates reflect the average expected inflation rate over the next 20 to 30 years, and this average does not change as radically as year-to-year expectations. 6-3 Interest rates will fall as the recession takes hold because (1) business borrowings will decrease and (2) the Fed will increase the money supply to stimulate the economy. Thus, it would be better to borrow short-term now, and then to convert to long-term when rates have reached a cyclical low. Note, though, that this answer requires interest rate forecasting, which is extremely difficult to do with better than 50% accuracy. 6-4 a. If transfers between the two markets are costly, interest rates would be different in the two areas. Area Y, with the relatively young population, would have less in savings accumulation and stronger loan demand. Area O, with the relatively old population, would have more savings accumulation and weaker loan demand as the members of the older population have already purchased their houses and are less consumption oriented. Thus, supply/demand equilibrium would be at a higher...
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