P c1i c 1i 2 cf1i t we know the payments and the

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P= C/(1+i) + C/ (1+i) 2 + ... + (C+F)/(1+i) t ** We know the payments and the bond’s price and we use the equation to derive i. Rate of Return – two ways of potentially increasing wealth by holding it for a year. The security may pay directly. Bond may yield a coupon payment. May receive dividends from stock ownership. Price of the security may change. If the price rises, you own a more valuable asset, so your wealth rises. ( Capital Gain/ (Loss) ) Capital Gain: Increase in an asset holder’s wealth from a change in the asset’s price Capital Loss: Decrease in an asset holder’s wealth from a change in the asset’s price Return: Total earnings from a security; the capital gain or loss plus any direct payment Return = (P1-P0) +X Rate of Return: return on a security as a percentage of its initial price Rate of return = [(P1-P0)/P0] + (X/P0) ** first part is the change in security price, and the second part is the direct payment divided by the initial price 3.7 Real and Nominal Interest Rates Nominal Interest rate: rate offered by a bank account or a bond Real Interest rate: nominal rate minus the inflation rate R ex ante = i – π expected What is the real interest rate? Answered by two different definitions: Ex ante real interest rate: nominal rate minus the inflation rate that people expect when a bond is sold Ex post real interest rate: nominal rate minus the actual inflation rate R ex post = i – π actual
Chapter 4 4.1 Loanable Funds Theory Loanable Funds Theory: the real interest rate is determined by the supply and demand for loans. Based on central idea of channeling funds. Interest rate = price of a loan (what investors pay savers for using their funds) Demand for loans = investment Capital inflows: funds provided to a country’s investors by foreigners Capital outflows: funds provided to foreign investors by a country’s savers Supply of loans = saving + net capital inflows **positive net inflows raise the supply of loans above level of saving, negative do the reverse Effects of the Real Interest Rate On Loan Demand: Rise in the real interest rate means higher costs, making it less likely the firm will decide to build the factory Increased real interest rate --> decreased investment --> decreased quantity loans demanded On Supply: higher interest rate means higher returns to savers and encourages people to save more Increased real interest rate --> increased saving Higher interest rates increase capital inflows to the United States Increased real interest rate --> increased net capital inflows Summary: Increased real interest rate --> increased saving and increased net capital inflows --> increased in quantity of loans supplied 4.2 Determinants of Interest Rates in the Loanable Funds Theory Interest rate changes when there is a shift in the supply or demand for loans. Differences between shifts and movements along the curves.

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