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Unformatted text preview: rn. In both cases the supplier is compensated for providing
funds. Ignoring risk factors, the cost of funds results from the real rate of interest
adjusted for inflationary expectations and liquidity preferences—general preferences of investors for shorter-term securities. The Real Rate of Interest
Assume a perfect world in which there is no inflation and in which funds suppliers
and demanders are indifferent to the term of loans or investments because they
have no liquidity preference and all outcomes are certain.1 At any given point in
time in that perfect world, there would be one cost of money—the real rate of
interest. The real rate of interest creates an equilibrium between the supply of savings and the demand for investment funds. It represents the most basic cost of
money. The real rate of interest in the United States is assumed to be stable and
equal to around 1 percent.2 This supply–demand relationship is shown in Figure
6.1 by the supply function (labeled S0) and the demand function (labeled D). An
equilibrium between the supply of funds and the demand for funds (S0 D)
occurs at a rate of interest k0 , the real rate of interest.
Clearly, the real rate of interest changes with changing economic conditions,
tastes, and preferences. A trade surplus could result in an increased supply of 1. These assumptions are made to describe the most basic interest rate, the real rate of interest. Subsequent discussions relax these assumptions to develop the broader concept of the interest rate and required return.
2. Data in Stocks, Bonds, Bills and Inflation, 2001 Yearbook (Chicago: Ibbotson Associates, Inc., 2001), show that
over the period 1926–2000, U.S. Treasury bills provided an average annual real rate of return of about 0.7 percent.
Because of certain major economic events that occurred during the 1926–2000 period, many economists believe that
the real rate of interest during recent years has been about 1 percent. CHAPTER 6 Interest Rates and Bond Valuation 265 FIGURE 6.1
Real Rate of Interest Supply–Demand
Supply of savings and
demand for investment funds S0
S0 = D S1 = D...
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