CH13+solutions - Chapter 13 An introduction to interest...

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Chapter 13 An introduction to interest rate determination and forecasting In forming a view on the future direction of interest rates, it is necessary to recognise that changes in monetary policy settings are likely to affect the state of the economy, which in turn affects interest rates generally. For example, when a monetary-policy-induced increase in interest rates causes a reduction in the pace of economic growth, the demand for funds begins to decline and the rate of interest begins to ease. Furthermore, there is likely to be an accompanying reduction in the rate of inflation, thus causing interest rates to fall further. Within the macroeconomic context, these progressive changes are referred to as the liquidity effect, the income effect and the inflation effect on interest rates. Therefore, in trying to forecast the state of an economy and future interest rates, policy makers, economists and financial market participants often consider a range of economic indicators. Indicators may be described as leading, coincident and lagging indicators of future economic activity. A more disciplined approach to forming a view on the future of interest rates is provided by the loanable funds approach. In this approach, the supply of loanable funds is identified as being determined by the savings of the household sector, changes in the money supply and the hoarding or dishoarding that takes place in response to changes in the rate of interest. The demand for funds originates from the business sector and the government sector. The prevailing rate of interest is the rate that equates the demand for and the supply of loanable funds. Factors that cause the demand or supply to change will result in a change in the rate of interest. While the framework is useful in identifying impacts on interest rates, its major shortcoming is that the supply and demand curves are interdependent. As a result, it is not possible to determine a unique equilibrium interest rate. One of the other shortcomings of the loanable funds approach is that it addresses interest rate determination as if only one interest rate exists at a particular time. This is clearly not the case in reality. At any point there are many rates of interest. The differences in rates reflect the different terms to maturity of instruments and the credit risk of a borrower. Differences between the rates on instruments of similar risk, but with different terms to maturity, are explained by theories of the term structure of interest rates. The term structure of interest rates is represented by a yield curve. The yield is the rate of return on debt instruments and a yield curve graphs the relationship between interest rates and the term to maturity of debt instruments in the same risk class. The shape of the yield curve may be normal, inverse, humped or flat. The expectations theory argues that, in an efficient market, interest rates on longer-term instruments are determined by two factors: the current short-term interest rate and the
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CH13+solutions - Chapter 13 An introduction to interest...

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