Capital Markets

Interest Rates

• What are some major interest rates in financial markets? Be as specific as possible.

Nominal and Real Interest Rates

• Nominal return represents how much money you will receive after 1 year for giving up 1 dollar of money today

• Real return represents how many goods you can buy if you give up the opportunity to buy 1 good today.

• Nominal interest rate is money interest rate. Real interest rate is goods interest rate.

Real Interest Rate

• The real interest rate on the loan is defined as the future goods received relative to current goods foregone

11

$1 $11

$1

11

1

t+1t

t+1

t t

tt t t t

t

i iP 1r

PP P

ir r i

Ex Ante Rate and the Fisher Effect• Savings and investment decisions must be

made before future inflation is known so they must be made on the basis of an ex ante (predicted) real interest rate.

1EA FORECAST

t t ti r

Measuring the Real Interest Rate

• Long-term

1. Use the yield on inflation protected securities.

• Short-term

1. Use nominal interest minus consensus inflation forecast

2. Use nominal interest rate minus your own inflation forecast

TIPS Bond

• The US Treasury offers bonds whose principal and coupon payments increase with the inflation rate.

• Investors are paid off in terms of real purchasing power.

• Yield is equivalent to a real interest rate.

Additional Information from U.S. Treasury

Real & Nominal Interest Rates

π10 Year Forecast

http://research.stlouisfed.org/fred2/categories/22

Expected Inflation

• Surveys of professional forecasters might be one way of getting a good predictor of inflation.– For USA, available from Philadelphia Federal

Reserve Bank.– For other countries, available from Consensus

Forecasts. For a price!

1 1FORECAST SURVEYt t

Forecasts of Future Inflation

0

1

2

3

4

5

6

7

8

9

Se

p-8

1

Se

p-8

3

Se

p-8

5

Se

p-8

7

Se

p-8

9

Se

p-9

1

Se

p-9

3

Se

p-9

5

Se

p-9

7

Se

p-9

9

Se

p-0

1

Se

p-0

3

Se

p-0

5

Se

p-0

7

Se

p-0

9

%

1 Year Inflation 10 Year Inflation

Consensus Forecasts

Estimated Real Rates for USA

-6

-4

-2

0

2

4

6

8

10

1975 1980 1985 1990 1995 2000 2005

Real Interest Rate - Current InflationReal Interest Rate - Professional Forecast Inflation

•If a professional forecast is not available, we might want to use today’s inflation as a substitute.

1FORECASTt t

Loanable Funds Market

Loanable Funds Market• Consider the financial market at its broadest

and most abstract. – an amalgamation of the bond market and the

lending market (banks, etc.)

• Map the relationship between the interest rate and the quantity of funds that are lent.– Supply curve represents the behavior of savers &

lenders– Demand curve represents the behavior of

borrowers

Supply Curve: Loanable Funds

• Why does the supply curve slope up?– When real interest rates offered by banks are

high, savers are rewarded with more future consumption and are likely to be induced to save more.

– Caveat: If some savers are setting a target for their level of wealth at retirement, a higher interest rate reduces the amount they need to save. • For this reason, many economists believe saving

curve is very inelastic.

Demand Curve: Loanable Funds

• Why does the demand curve slope down?– Firms borrow to finance investment projects. If the

return on investment falls below the interest rate, the project is not worthwhile. The higher the interest rate, the fewer projects fall below the hurdle.

– Households borrow to finance housing. The higher are interest rates, the smaller is the house that the householders can buy with a mortgage payment that they can afford.

Globalization and the Loanable Funds Market

• Even ten years ago, we might have thought of the loanable funds market as being national in nature – especially for large economies. These days it appears that even the USA is part of a single global market. [China possible exception]

• Only very large changes in large countries or international trends will have an impact on real interest rates.

Competitive Market Equilibrium:Loanable Funds Market

(Geometry)

SLFDLF

LF

r*

LF*

r

Ex. Investment Boom in Emerging Markets

McKinsey Report S

D

LF

r*

LF*

r

r**

D'

LF**

1

2

http://www.bea.gov/national/nipaweb/SelectTable.asp?Selected=Y

Ex. US Consumers become thriftier

SD

LF

r*

LF*

r

LF**

S'

r**

1

2

Savings

• We divide savings into 2 parts:

SPrivate Private Saving

(Household + Business Saving)

+SPublic Public Saving/Government Saving

(Budget Surplus)

= S National Saving

Public Savings is part of the supply of loanable funds if positive and part of demand for loanable funds if negative (as usual).

Example: Government strikes a deal to raise taxes and cut spending

S'D

LF

r*

LF*

r

r**

S

LF**

1

2

Ex.Japanese Government runs a deficitBudget Plan

D'

D

LF

r*

LF*

r

r**

S

LF**

1

2

National Economy

• How do national economies relate to the global financial market?

1. Countries will face an external interest rate, rW, unaffected by national savings or investment.

2. International capital flows will make up the gap between savings and investment.

Competitive Market Equilibrium:Loanable Funds Market

SD

LF

r*

LF*

r

S+KA

KA

Investment Boom[r Doesn’t Rise, Gap made up by Capital Inflows]

SD

LF

rW

LF*

rD'

LF**

12KA

Consumers become thriftier(r does not fall, gap made up by capital

outflows)

S

LF

rW

r

12 -KA

D

S'

Savings Glut

• Theory put forth by Fed Chairman explaining the U.S. trade deficit: Washington Post Article

World Interest Rate Falls(Global Economy)

D

LF

rW

r

S+KA1

2

S

rW' 2

Net Capital Outflows = ‘Goods & Income Outflows

• Private Savings: Y + NFI -Tax – C

• Public Savings: Tax – G

• National Savings: S = Y+ NFI – C – G

• Capital Outflows: -KA = S – I

S-I = NFI + (Y – C – G – I)= NFI +NX

http://www.bea.gov/national/nipaweb/SelectTable.asp?Selected=Y

US Current Account

-7.00%

-6.00%

-5.00%

-4.00%

-3.00%

-2.00%

-1.00%

0.00%

1.00%

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

NX NFI CA

Learning Outcome• Calculate the relationship between inflation,

expected inflation, interest rates and real interest rates.

• Use the Loanable Funds model to analyze the effects of external events on savings, investment, and real interest rates in capital markets.