CHAPTER 4:
THE BEHAVIOR OF INTEREST RATE
FOUR TYPES CREDIT INSTRUMENT
Simple Loan
Fixed Payment Loan
Coupon Bond
Discount Bond
Determination of Interest Rates
The classical model
Determination of the Market Interest Rate
Determinants of Asset Demand
An asset is a piece of property that is a store of value
1. Wealth
2. Expected return
3. Risk
4. Liquidity
Theory of Asset Demand
All the determining factors above can be assembled into the theory of asset demand
The quantity demanded of an asset is positively related to wealth
The quantity demanded of an asset is positively related to its expected return relative to alternative assets
The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets
The quantity demanded of an asset is positively related to its liquidity relative to alternative assets
Interest Rate Determination in a Economic System
An Introduction(Demand and Supply in the Credit market)
Subtopic
CONCEPTS OF NOMINAL AND REAL INTEREST RATES
Nominal Interest Rate
Is the rate of interest that is accrued at some time in the future
Nominal interest rate makes no allowance for inflation , that is, it ignores the effects of inflation
Real Interest Rate
An interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower, and the real yield to the lender. The real interest rate of an investment is calculated as the amount by which the nominal interest rate is higher than the inflation rate. Real Interest Rate = Nominal Interest Rate - Inflation (Expected)
Concepts of Interest Rates and Rate of Return
Interest Rate
Rates of Returns (ROR)
Measuring Interest Rate
Yield to Maturity
YIELD TO MATURITY
YTM is the most accurate measure Interest Rate
YTM is interest rate that equates the Present Value Payments received from a debt instrument with current value.
YTM also called the Internal rate of return (IRR)
The crowding-Out Effect (Government Deficit Spending)
Demander/ buyer bond =
Supplier loanable fund
supplier/ seller bond = demander loanable fund
Subtopic
SHIFTS IN BOTH DEMAND AND SUPPLY OF BONDS
CHANGES IN EXPECTED INFLATION : THE FISHER EFFECT
*expected inflation ↑,expected return on bond relative to real assets or goods falls for any given price and interest rate.
*When expected inflation rises, interest rates will rise.
*When expected inflation fallen, interest rates will fall.
The liquidity preference framework
The keynesian approach focuses on the supply of money and demand of money.
Total wealth= total money + total Q of bonds in economic.
Keynes holding highly liquid money:
*Transaction
*Precaution
*speculation
SUPPLY OF BONDS
Factors that influence the supply curve to shift
Expected profitability of investment opportunities
Expected inflation
if the expected inflation increased, the real interest rate falls.
Government activities/borrowing
decision by governments can affect bond prices and interest rates in the economy.