Interest Rates

# Interest Rates - Interest Rates ECON 3382-02 A. Hales...

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Interest Rates ECON 3382-02 A. Hales Spring 2010

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Nominal and real interest rates Nominal interest rate : does not adjust for inflation. Real interest rate : interest rate that is adjusted for inflation. It more accurately reflects the true cost of borrowing.
The Fisher Equation States that the nominal interest rate (i) equals the real interest rate (i*) plus the expected rate of inflation,πe . Rewriting: Consider the following: If you make a one-year loan with a 5% interest (i=5%) and you expect the price level to rise by 3% (πe ) then you expect to have 2% more in real terms (or in goods and services that you can purchase). e i i π + = * e i i - = *

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Class Exercise What is the real interest rate if the nominal interest rate is 8% and the expected inflation rate is 10% over the course of a year? Implications for borrowing and lending:
How are inflation expectations formed? Economists do not agree on the answer to this question but many think that a reasonable explanation is adaptive expectations . Adaptive expectations: theory that people’s expectations of a variable are based on past levels of the variable; also, backward-looking expectations. In other words, individuals look at what inflation rates were in the past to make judgments about inflation rates in the future.

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What determines interest rates? Two Theories The loanable funds theory : explains how real interest rates are determined. The liquidity preference theory : explains how nominal interest rates are determined.
Loanable Funds Theory States that real interest rates are determined by the supply and demand for loans. The intuition is that financial markets match savers and borrowers. Specifically, they are matched in a market for loans (loanable funds). This market determines the price of loans—the interest rate. Theory is simplistic in that it assumes one type of loan and one interest rate in the economy. Also, it does not allow for financial intermediaries such as banks. However, it offers valuable insights into real interest rate determination.

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Loanable Funds Theory: The demand for loans Since loans are used to finance investment, the demand for loans is the level of investment in the economy. If investors want to undertake more projects, they must invest more. Demand for loans=investment The impact of changes in the real interest rate: If the real interest rate increases, the cost of borrowing rises. If the cost of borrowing rises, then the level of
Loanable Funds Theory: The supply of loans The supply of loans is more complicated. Investors borrow from savers, which suggests that the supply of loans should equal the level of savings in the economy. This is only true in a closed economy (one with no interaction with foreign economies). However, in an open economy there are also capital

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Interest Rates - Interest Rates ECON 3382-02 A. Hales...

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