Answers to End-of-Chapter Questions
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.
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.
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.
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.
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.
Chapter 6: Interest Rates