Week 3, Chapter 5 questions 1,3,5,7 problem 10
1. Explain how an interest rate is just a price.
Like all prices, it is determind in a market through supply and demand.
3. Why is it so important to match the frequency of the interest rate to the frequency
of the cash flows?
A change in interest rates will affect consumers' and firms' cash flow, ie the
amount of cash they have available. For savers, a rise in interest rates will increase the
money received from interest-bearing bank and building society deposits. But it will also
mean higher interest payments for people and firms with loans - debtors - who are being
charged variable interest rates (as opposed to fixed rates which do not change). These
include many households with mortgages on their homes. These fluctuations in cash flow
are likely to affect spending. Lower interest rates will have the opposite effects on savers
and borrowers.
5. What mistake do you make when you discount real cash flows with nominal
discount rates?
Equity investors incorrectly discount real cash flows with nominal discount rates.
Thus when inflation is high (low), the rational equity-premium expectation is higher
(lower) than the market’s subjective expectation.
7. Can the nominal interest rate available to an investor be negative? (Hint:
Consider the interest rate earned from saving cash “under the mattress.”) Can the

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