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CHAPTER 4 THE LEVEL OF INTEREST RATES CHAPTER OBJECTIVES 1. This chapter defines the concept of an interest rate and examines the forces that establish the level of interest rates in the economy. 2. The chapter distinguishes between the concepts of the real interest rate and a nominal interest rate, with particular attention to the effect of inflation. 3. The chapter surveys Loanable Funds Theory and its implications for forecasting interest rates. CHANGES FROM THE LAST EDITION Exhibits have been updated. CHAPTER KEY POINTS 1. Interest is the “rent” on borrowed money. An interest rate is the price of “renting” or borrowing another’s purchasing power; thus credit or borrowed money is a priceable commodity. Interest penalizes the borrower for consuming before earning and rewards the lender for postponing consumption. 2. The fundamental long-run interest rate in the economy is the real rate of interest. It is called the “real” rate of interest because it is determined by the real output of the economy. It is determined at equilibrium between the demand for financing for productive real assets and the supply of savings. By definition it is the minimum rate of return necessary to offset the positive time preference for consumption in the absence of any transactional risk or expected change in purchasing power. 3. Loanable Funds Theory is a comprehensive theory of interest rate determination in financial activity. The trade-off between productivity and thrift is the basic force in interest rates, but not the full explanation of short-run changes in interest rates observed in a complex financial system . Interest rates can be substantially influenced by demand for and supply of financial claims, trading in secondary markets that do not link directly to the real sector. Thus, interest rates in the near term depend on supply of and demand for loanable funds. The supply of loanable funds comprises all sources of funds invested in financial claims: 1. Consumer savings. 2. Business savings (depreciation, amortization, and retained earnings). 3. Government budget surpluses. 4. Central bank action. The demand for loanable funds comprises all uses of funds raised by issuing financial claims: 1. Consumer credit purchases. 2. Business investment. 3. Government budget deficits. If competitive forces operate in the financial sector, laws of supply and demand will bring interest rates
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in each market into equilibrium. The equilibrium, however, is temporary and dynamic. Any force that shifts supply or demand will tend to change interest rates. 4.
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This note was uploaded on 03/24/2011 for the course FINA 409 taught by Professor John during the Spring '11 term at Ohio State.

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