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Unformatted text preview: Chapter 5: Introduction to Risk, Return, and the Historical Record 5.1 Determinants of the Level of Interest Rates • Fundamental Factors that determine the level of interest rates: o The supply of funds from savers, primarily households o The demand for funds from businesses to be used to finance investments in plant, equipment, and inventories ( real assets or capital formation) o The government’s net supply of or demand for funds as modified by actions of the Federal Reserve Bank • Real and Nominal Rates of Interest o Interest rate- promised rate of return denominated in some unit of account over some time period o Nominal interest rate- the growth rate of your money o Real interest rate- the growth rate of your purchasing power o r = R – I r=real rate, R= nominal rate, i= inflation rate o I + r = 1+R/ 1+i o r = R – i / 1 + i o certificates of deposit offer guaranteed nominal rate of interest • The Equilibrium Real Rate of Interest o Supply, demand and government actions as well as expected rate of inflation determine the real interest rate o At higher real interest rates households will choose to postpone some current consumption and set aside or invest more of their disposable income for future...
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