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Unformatted text preview: Finance 341 Chapter 6 Interest Rates Four most fundamental factors affecting the cost of money are: o Production Opporunities : the investment opportunities in productive (cash- generating) assets o Time preferences for consumption : the preferences of consumers for current consumption as opposed to saving for future compensation o Risk : in a financial market context, the chance that an investment will provide a low or negative return o Inflation : the amount by which prices increase over time The interest rate paid to savers depends : o (1) on the rate of return that producers expect to earn on invested capital o (2) on savers time preferences for current vs. future consumption o (3) on the riskiness of the loan o and (4) on the expected future rate of inflation. Higher risk and higher inflation also lead to higher interest rates Interest Rate Levels : o Borrower bid for the available supply of debt capital using interest rates: the firms with the most profitable investment opportunities are willing and able to pay the most for capital, so the tend to attract it away from inefficient firms and firms whose products are not in demand. o The supply curve in each market is upward-sloping, which indicates that investors are willing to supply more capital the higher the interest rate they receive on their capital. o The downward-sloping demand curve indicates that borrowers will borrow more if interest rates are lower. o Increased availability of capital will push down interest rates o There are markets for home loans, farm loans, business loans, federal, state, and local government loans, and consumer loans. o When the economy is expanding, firms need capital, and this demand pushes interest rates up. Also, inflationary pressures are strongest during business booms, and this pushes interest rates up as well. o Conditions are reversed during recessions: slack business reduces the demand for credit, inflation falls, and the Federal Reserve increases the supply of funds to help stimulate the economy. The result is a decline in interest rates. o The current interest rate minus the current inflation rate is defined as the current real rate of interest. o An increase in interest rates will encourage investors to transfer funds from the stock market to the bond market o In the years ahead, we can be sure of two things: (1) interest rates will vary And (2) they will increase if inflation appears to be headed higher or decrease if inflation is expected to decline Real risk-free rate of interest (k*): the rate that would exist on a riskless security in a...
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