Podcast
Questions and Answers
The reward for saving is the rate of ______ on loans that savers make with their unconsumed income.
The reward for saving is the rate of ______ on loans that savers make with their unconsumed income.
interest
Investment means directing resources to assets that will increase the firms’ future capacity to ______.
Investment means directing resources to assets that will increase the firms’ future capacity to ______.
produce
The maximum that a firm will invest depends on the rate of interest, which is the cost of ______.
The maximum that a firm will invest depends on the rate of interest, which is the cost of ______.
loans
An increase in technological capability makes production ______.
An increase in technological capability makes production ______.
Signup and view all the answers
When individuals become more willing to save, it results in a fall in the marginal rate of time ______.
When individuals become more willing to save, it results in a fall in the marginal rate of time ______.
Signup and view all the answers
An interest rate is the price paid by a borrower to a lender for the use of resources during some ______.
An interest rate is the price paid by a borrower to a lender for the use of resources during some ______.
Signup and view all the answers
The ______ rate is the growth in the power to consume over the life of a loan.
The ______ rate is the growth in the power to consume over the life of a loan.
Signup and view all the answers
Keynes’s theory of interest revolves around the concept of ______ preference.
Keynes’s theory of interest revolves around the concept of ______ preference.
Signup and view all the answers
Fisher’s theory of interest suggests that saving is the choice between current and future ______ of goods and services.
Fisher’s theory of interest suggests that saving is the choice between current and future ______ of goods and services.
Signup and view all the answers
The ______ rate is the number of monetary units to be paid per unit borrowed.
The ______ rate is the number of monetary units to be paid per unit borrowed.
Signup and view all the answers
Keynes assumed that most people hold wealth in only two forms: 'money' and ______.
Keynes assumed that most people hold wealth in only two forms: 'money' and ______.
Signup and view all the answers
The demand for money is a negative function of the ______ rate.
The demand for money is a negative function of the ______ rate.
Signup and view all the answers
An increase in the money supply would shift the supply curve to the right, leading to a decline in the equilibrium ______.
An increase in the money supply would shift the supply curve to the right, leading to a decline in the equilibrium ______.
Signup and view all the answers
A rise in income raises the value of money’s liquidity and shifts the demand curve to the ______.
A rise in income raises the value of money’s liquidity and shifts the demand curve to the ______.
Signup and view all the answers
The central bank can alter the amount of money available in the economy through ______ market operations.
The central bank can alter the amount of money available in the economy through ______ market operations.
Signup and view all the answers
The equilibrium interest rate would fall from i to ______.
The equilibrium interest rate would fall from i to ______.
Signup and view all the answers
Fisher’s theory neglects the power of the government to create ______.
Fisher’s theory neglects the power of the government to create ______.
Signup and view all the answers
The demand for funds is negatively related to the ______.
The demand for funds is negatively related to the ______.
Signup and view all the answers
In an equilibrium situation, the demand for funds equals the ______ of funds.
In an equilibrium situation, the demand for funds equals the ______ of funds.
Signup and view all the answers
The Liquidity Preference Theory analyzes the equilibrium level of the interest rate through the interaction of the supply of ______ and the public’s aggregate demand.
The Liquidity Preference Theory analyzes the equilibrium level of the interest rate through the interaction of the supply of ______ and the public’s aggregate demand.
Signup and view all the answers
Study Notes
Chapter Three: Interest Rates in the Financial System
- Interest rates are the price borrowers pay lenders for the use of resources.
- The principal is the amount of the loan.
- Interest is typically expressed as a percentage of the principal per unit of time (often a year).
- Real rate: the rate that would prevail if average prices remained constant for the loan's life.
- Risk-free rate: the rate on a loan where the borrower will not default.
- Short-term rate: the rate on a loan with a one-year maturity.
- Nominal rate: the observable market rate on a loan.
Types of Interest Rates
- Fisher's Law: (1 + i) = (1 + r) × (1 + p) where:
- i = nominal interest rate
- r = real interest rate
- p = expected percentage change in price level
- Nominal rate reflects both real rate and expected inflation.
The Theory of Interest Rates
- Two influential theories:
- Fisher's theory of interest (underlying the loanable funds theory)
- Keynes's liquidity preference theory of interest
Fisher's Theory of Interest Rate
-
Saving involves choosing between present and future consumption.
-
Individuals save to consume more in the future.
-
Marginal rate of time preference: willingness to trade present consumption for future consumption.
-
Current income affects saving decisions, though time preferences differ among individuals.
-
The interest rate is the reward for saving.
-
Investment: directing resources to assets that boost a firm's future production.
-
No demand for borrowing means no reward for savings.
-
Investment gains depend on the marginal productivity of capital (inversely proportional to investment).
-
Investment depends on the interest rate (cost of borrowing); the firm invests as long as gains exceed or equal the cost.
The Loanable Funds Theory
- Interest rates are determined by the interaction of:
- Total demand for funds (by firms, governments, households) which is inversely proportional to interest rate
- Total supply of funds (by firms, governments, banks, individuals) which is positively proportional to interest rate
- Equilibrium occurs when demand equals supply.
The Liquidity Preference Theory
- Equilibrium in the money market is analyzed by considering supply and demand for money holding in the forms of money and bonds
- Individuals hold money for transactions, caution, and speculation about rising interest rates
- The demand for money is inversely related to interest rates; low rates result in holding more money. High rates encourage holding bonds.
- Changes in money supply can affect interest rates and economic activity.
Determinants of the Structure of Interest Rates
- Interest rates depend on myriad factors, including:
- Default risk
- Liquidity
- Tax considerations
Risk Structure of Interest Rates
- Bonds with the same maturity can have different interest rates due to varying default risks, liquidity, and tax considerations.
- Default risk: the probability that the issuer cannot or will not make payments on a bond.
- Risk premium: the difference in interest rates between bonds with default risk and U.S. treasury bonds.
- Liquidity: the ease with which an asset can be converted into cash
- Investors require compensation for the increased risk of buying bonds (longer term).
Term Structure of Interest Rates
- The relationship among bonds with the same risk characteristics but different maturities is the term structure of interest rates
The Expectations Hypothesis
- The expectations hypothesis focuses on the risk-free rate
- Assumes certainty about the future to determine an equivalent value for two year with two one year bonds
- If interest rates are expected to rise, the yield curve will be upward sloping
- If interest rates are expected to fall , the yield curve will be downward sloping.
- If rates expected to stay same, then the yield curve is flat
Studying That Suits You
Use AI to generate personalized quizzes and flashcards to suit your learning preferences.
Related Documents
Description
Explore the fundamentals of interest rates in the financial system in this quiz. Understand concepts such as nominal and real rates, as well as key theories like Fisher's and Keynes's. Test your knowledge on various types of interest rates and their implications on borrowing and lending.
