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Unformatted text preview: Chapter 6: Interest Rates Learning Objectives 113 Chapter 6 Interest Rates Learning Objectives After reading this chapter, students should be able to: List the various factors that influence the cost of money. Discuss how market interest rates are affected by borrowers’ need for capital, expected inflation, different securities’ risks, and securities’ liquidity. Explain what the yield curve is, what determines its shape, and how you can use the yield curve to help forecast future interest rates. 114 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 ½ 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 rate of interest in Area Y. b. Yes. Nationwide branching, and so forth, would reduce the cost of financial transfers between the areas. Thus, funds would flow from Area O with excess relative supply to Area Y with excess relative demand. This flow would increase the interest rate in Area O and decrease the interest rate in Y until the rates were roughly equal, the difference being the transfer cost. interest rate in Y until the rates were roughly equal, the difference being the transfer cost....
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This note was uploaded on 05/05/2010 for the course ECONMOICS ECON 203 taught by Professor Josephpetry during the Spring '10 term at University of Illinois, Urbana Champaign.
- Spring '10