Finance Chapter 3: Interest Rates

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Questions and Answers

What does the expectations hypothesis imply about long-term interest rates when interest rates are expected to rise?

They will be higher than short-term interest rates. (correct)

They will fluctuate randomly with no clear trend.

They will be equal to short-term interest rates.

They will be lower than short-term interest rates.

According to the expectations hypothesis, how is the two-year interest rate calculated?

It is derived from the difference between short-term and long-term bonds.

It equals the average of the current one-year rate and the expected one-year rate one year from now. (correct)

It is the product of the current one-year rate and the future one-year rate.

It is the geometric average of the current one-year rate and future rates.

What shape does the yield curve take if interest rates are expected to remain the same?

It slopes upward.

It is flat. (correct)

It shows irregular fluctuations.

It slopes downward.

How can bonds of different maturities be considered in the expectations hypothesis?

They are perfect substitutes and can offer the same yields. Signup and view all the answers

Which condition will result in a downward sloping yield curve according to the expectations hypothesis?

Interest rates are expected to fall. Signup and view all the answers

What is the relationship between the interest rate and the willingness to save?

Higher interest rates generally lead to an increased willingness to save. Signup and view all the answers

What primarily influences a firm's borrowing decision according to Fisher's theory?

The expected gain from investment being greater than the cost of loans. Signup and view all the answers

How does an increase in technological capability affect investment according to Fisher's theory?

It results in higher marginal productivity of capital and increased desired investment. Signup and view all the answers

What happens to the supply of loans when individuals become more willing to save?

The supply of loans shifts downward. Signup and view all the answers

What effect does increased investment have on the marginal productivity of capital?

It causes marginal productivity to decline as less profitable projects are pursued. Signup and view all the answers

How does the firm’s demand for borrowing relate to the interest rate?

Demand for borrowing is inversely related to the interest rate. Signup and view all the answers

What is the maximum investment level a firm will pursue related to?

The marginal productivity of capital as compared to the interest rate. Signup and view all the answers

What are the two primary forms of wealth that Keynes assumed people hold?

Money and bonds Signup and view all the answers

What is the relationship between interest rates and the demand for money according to Keynes?

Demand for money is a negative function of the interest rate Signup and view all the answers

What effect does an increase in income have on the demand curve for money?

It shifts the demand curve to the right, increasing the equilibrium interest rate Signup and view all the answers

Which entity has the power to shift the money supply curve according to Keynes?

The central bank Signup and view all the answers

What happens to the equilibrium interest rate when the money supply is increased?

It decreases Signup and view all the answers

How does a change in expected inflation influence the demand for money?

It shifts the demand curve to the right Signup and view all the answers

Why do people tend to hold more money when interest rates are low?

Liquidity costs are low Signup and view all the answers

Which action by the central bank increases the money supply?

Buying government securities Signup and view all the answers

What is the implication of people preferring to hold bonds at high interest rates?

They expect interest rates to fall Signup and view all the answers

What is the liquidity effect in relation to changes in the money supply?

It represents the initial reaction of interest rates to a change in the money supply. Signup and view all the answers

How does an increase in the money supply typically affect income levels in the economy?

It raises income by increasing loan availability and consumer spending. Signup and view all the answers

What is the primary consequence of the price expectations effect when money supply increases?

It results in an increase in interest rates due to expectations of price level changes. Signup and view all the answers

What can cause the various effects of changes in money supply to not occur simultaneously?

Different time frames for the economy's adjustment processes. Signup and view all the answers

What should be expected if the money supply grows during a period of high output?

An increase in income dependent on much slack exists in the economy. Signup and view all the answers

Which statement correctly describes the relationship between demand for money and income levels?

An increase in income raises the demand for money at any interest rate. Signup and view all the answers

What characterizes the risk structure of interest rates?

It involves multiple interest rates reflecting different risk levels and economic conditions. Signup and view all the answers

Which of the following best describes the income effect related to money supply changes?

An increase in money supply generally elevates income through greater loan accessibility. Signup and view all the answers

What might happen if the money supply does not align with the current economic context?

The impacts of money supply changes may become muted or contrary to expectations. Signup and view all the answers

What is the primary reason bonds with the same maturity can have different interest rates?

Default risk, liquidity, and tax considerations Signup and view all the answers

What does the risk premium indicate?

The difference between yields on default-risk bonds and Treasury bonds Signup and view all the answers

Which of the following best describes liquidity in the context of bonds?

The ease of converting an asset into cash Signup and view all the answers

Why might long-term bonds generally offer higher yields compared to short-term bonds?

Investors require compensation for the increased uncertainty over a longer period. Signup and view all the answers

Which statement accurately reflects the expectations hypothesis of the term structure of interest rates?

It focuses on computing the risk-free interest rate without uncertainty. Signup and view all the answers

What is the term structure of interest rates concerned with?

The relationship between bonds with the same risk characteristics but different maturities Signup and view all the answers

What happens to the yields on short-term bonds in comparison to long-term bonds according to general trends?

They are more volatile than long-term bond yields. Signup and view all the answers

How are the interest payments on municipal bonds typically treated for tax purposes?

Exempt from federal income taxes Signup and view all the answers

What can lead to a wider spread between the yields of corporate bonds and Treasury bonds?

An increase in perceived default risk of corporate bonds Signup and view all the answers

Which of the following factors is not typically a determinant of the structure of interest rates?

Issuer's geographical location Signup and view all the answers

Study Notes

Chapter Three: Interest Rates in the Financial System

Interest rates are the price paid by a borrower to a lender for the use of resources.
The amount borrowed is the principal.
The price is usually expressed as a percentage of the principal per unit of time (usually a year).

Types of Interest Rates

Real rate: The rate that would prevail if average prices for goods and services remained constant during the loan's life. This is the growth in the power to consume over the life of a loan.
Risk-free rate: The rate that a borrower would pay on a loan where there is no risk of default.
Short-term rate: The rate on a loan with a one-year maturity.
Nominal rate: The observable market rate on a loan, representing the monetary units paid per unit borrowed.

The Relationship Between Inflation and Interest Rates (Fisher's Law)

Fisher's Law describes the relationship between nominal interest rates (i), real interest rates (r), and expected inflation (p).
The formula is: (1 + i) = (1 + r) × (1 + p)
Nominal interest rate reflects both the real rate and expected inflation.

The Theory of Interest Rates

Two major theories are Fisher's theory and Keynes's liquidity preference theory.
Fisher's theory is an underlying principle of the loanable funds theory.

Fisher's Theory of Interest Rates

Saving is the decision between current and future consumption of goods and services.
Individuals save some current income to consume more later.
The marginal rate of time preference is a key factor in saving decisions. This is willingness to trade some consumption now for more future consumption.
Current income also influences saving decisions; higher current income typically means more saving.
The rate of interest on loans that savers make with their unconsumed income is another important variable affecting saving decisions.
As interest rates rise, the willingness to save also rises.
There will be no reward for saving if there is no demand for borrowed resources. Someone must pay interest, and firms borrow to invest.
Investment means directing resources to assets that increase the firm's future production capacity.
A crucial part of the borrowing decision is the gain from investments, the positive difference between process resources used versus total resources.
The marginal productivity of capital is negatively related to investment. More investment leads to less additional gain.
A firm's maximum investment depends on the interest rate and the marginal productivity of capital.
Firms invest only if the gain from an investment is greater than or equal to the cost of the loan. Interest rate and firms' demand for borrowing are negatively related.

The Loanable Funds Theory

Interest rates are determined by the interaction of the total demand for funds (from firms, governments, and households) and the total supply of funds (from firms, governments, banks, and individuals).
Demand is negatively related to the interest rate (save some exceptions, such as government demand which is often not related to interest rates)
Supply is positively related to the interest rate.
Equilibrium occurs when the demand for funds equals the supply of funds.

The Liquidity Preference Theory

Developed by Keynes, this theory analyzes the equilibrium interest rate through the interaction of the money supply and the public's demand for holding money.
Money is held for transactions, precaution against events, and to speculate on rises in interest rates.
Money demand is a negative function of the interest rate.
Public demand for money is a function of income.
Higher income increases the amount of money individuals want to hold at every interest rate.
Shifts in the money supply curve happen because of central bank actions (open market operations).
Effects on interest rates from supply side changes usually spread out over time.

Changes in the Money Supply and Interest Rates

Changes in money supply affect interest rates through the liquidity, income, and price expectation effects. These effects can occur in a staggered fashion over time.
The liquidity effect is an initial reaction to a money supply change (with money supply change, initial interest rate reaction).
The income effect is the reaction to changing income (with income change, money demand and interest rate changes)
The price expectation effect occurs if the money supply grows at high output.

Risk Structure of Interest Rates

There isn't one interest rate; a structure exists with bonds having different interest rates due to risk factors.
Bonds of the same maturity term have different interest rates due to default risk, risk premium, and liquidity.
Default risk: Probability issuer is unable or unwilling to pay (US Treasury bonds are considered default free).
Risk premium: Spread between interest rates on bonds with default risk and those without.
Liquidity: Ease of converting an asset into cash.

Determinants of the Structure of Interest Rates

Interest rates depend on a variety of factors beyond tax status or bond ratings.

Term Structure of Interest Rates

The relationship among bonds with same risk characteristics but different maturities is called the term structure of interest rates.
Long-term bonds are like a composite of short-term bonds.
Their yields depend on investor expectations.
Comparing short-term (e.g., 3 months) and long-term (e.g., 10 years) Treasury yields allows analysis of relationships. Short-term yields are more volatile than long term. Long-term yields tend to be higher than short-term.

The Expectations Hypothesis

This hypothesis focuses on risk-free interest rates and calculates them assuming no uncertainty.
Investors are indifferent between holding a single bond with a longer term and buying a series of short-term bonds.
When interest rates are expected to rise, the yield curve slopes up.
When rates are expected to fall, the curve slopes down.

Other Sections

Additional material from this slide deck provides specific analysis of the above topics, including the specifics of the Liquidity Premium, and a brief application section.

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Explore the key concepts of interest rates in the financial system, including real, risk-free, short-term, and nominal rates. Understand the relationship between inflation and interest rates as described by Fisher's Law. This quiz will test your knowledge on how various types of rates function within existing economic frameworks.