Structure of

Interest Rate
Financial Market
Present Value
• A dollar paid to you one year from
now is less valuable than a dollar paid
to you today
• Why?
• A dollar deposited today can earn
interest and become $1 x (1+i) one
year from today.
 Discounting the Future
Let i = .10
In one year $100 X (1+ 0.10) = $110
In two years $110 X (1 + 0.10) = $121
or 100 X (1 + 0.10) 2
In three years $121 X (1 + 0.10) = $133
or 100 X (1 + 0.10)3
In n years
n
$100 X (1 + i)
 Simple Present Value

PV = today's (present) value

CF = future cash flow (payment)
i = the interest rate
CF
PV = n
(1 + i )
Time-Line

Cannot directly compare payments scheduled in different points in the

time line

$100 $100 $100 $100

Year 0 1 2 n

PV 100 100/(1+i) 100/(1+i)2 100/(1+i)n

Four Types of
Credit • Simple Loan
Market • Fixed Payment Loan
Instruments • Coupon Bond
• Discount Bond
 • The interest rate that
equates the
Yield to present value of cash
flow payments received
Maturity from a debt instrument
with
its value today
 Simple Loan

PV = amount borrowed = $100

CF = cash flow in one year = $110
n = number of years = 1
$110
$100 =
(1 + i )1
(1 + i ) $100 = $110
$110
(1 + i ) =
$100
i = 0.10 = 10%
For simple loans, the simple interest rate equals the
yield to maturity
 Fixed Payment Loan

The same cash flow payment every period throughout

the life of the loan
LV = loan value
FP = fixed yearly payment
n = number of years until maturity
FP FP FP FP
LV =  2
 3
 ...+
1 + i (1 + i) (1 + i) (1 + i) n
 Coupon Bond

Using the same strategy used for the fixed-payment loan:

P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity date
C C C C F
P=  2
 3
. . . + 
1+i (1+i ) (1+i) (1+i) (1+i ) n
n
 Table 1 Yields to
Maturity on a • When the coupon bond
is priced at its face value,
10%-Coupon-Rate the yield to maturity
Bond Maturing in equals the coupon rate
Ten Years • The price of a coupon
bond and the yield to
(Face Value = maturity are negatively
$1,000) related
• The yield to maturity is
greater than the coupon
rate when the bond
price is below its face
value
Consol or Perpetuity
• A bond with no maturity date that does not repay principal but pays fixed
coupon payments forever

P  C / ic
Pc  price of the consol
C  yearly interest payment
ic  yield to maturity of the consol

can rewrite above equation as this : ic  C / Pc

For coupon bonds, this equation gives the current yield, an easy to
calculate approximation to the yield to maturity
 Discount Bond
For any one year discount bond
F-P
i =
P
F = Face value of the discount bond
P = current price of the discount bond
The yield to maturity equals the increase
in price over the year divided by the initial price.
As with a coupon bond, the yield to maturity is
negatively related to the current bond price.
Rate of Return
The payments to the owner plus the change in value
expressed as a fraction of the purchase price
C P -P
RET = + t1 t
Pt Pt
RET = return from holding the bond from time t to time t + 1
Pt = price of bond at time t
Pt1 = price of the bond at time t + 1
C = coupon payment
C
= current yield = ic
Pt
Pt1 - Pt
= rate of capital gain = g
Pt
 The return equals the yield to maturity only if the
holding period equals the time to maturity

Rate of
Return and A rise in interest rates is associated with a fall in
bond prices, resulting in a capital loss if time to
Interest Rates maturity is longer than the holding period

The more distant a bond’s maturity, the greater

the size of the percentage price change associated
with an interest-rate change
 The more distant a bond’s
maturity, the lower the rate of
Rate of return the occurs as a result of
Return and an increase in the interest rate
Interest Rates
(cont’d)
Even if a bond has a substantial
initial interest rate, its return
can be negative if interest rates
rise
Table 2 One-Year
Returns on
Different-Maturity
10%-Coupon-Rate
Bonds When
Interest Rates Rise
from 10% to 20%
Interest-Rate Risk

Prices and returns for

long-term bonds are
more volatile than those
for shorter-term bonds

There is no interest-rate
risk for any bond whose
time to maturity
matches the holding
period
Real and
Nominal
Interest Rates

Nominal interest rate makes no allowance

for inflation

Real interest rate is adjusted for changes in

price level so it more accurately reflects the
cost of borrowing

Ex ante real interest rate is adjusted for

expected changes in the price level

Ex post real interest rate is adjusted for

actual changes in the price level
 Fisher Equation

i  ir   e
i = nominal interest rate
ir = real interest rate
 e = expected inflation rate
When the real interest rate is low,
there are greater incentives to borrow and fewer incentives to lend.
The real interest rate is a better indicator of the incentives to
borrow and lend.
 •Sources: Nominal rates from www.federalreserve.gov/releases/H15.
•The real rate is constructed using the procedure outlined in Frederic S.
Mishkin, “The Real Interest Rate: An Empirical Investigation,” Carnegie-
Rochester Conference Series on Public Policy 15 (1981): 151–200.
•This procedure involves estimating expected inflation as a function of past
Real and interest rates, inflation, and time trends and then subtracting the expected
inflation measure from the nominal interest rate.
Nominal
Interest Rates
(Three-Month
Treasury Bill),
1953–2008
Key Interest Rates
Loanable
Funds
Theory
The theory of market
interest rate
The Loanable Funds theory

We use the term “loanable funds

market” to describe the
arrangements and institutions by
which saving of households is
made available to borrowers.
1. Leakages must be recycled Fa
ct or
if total spending is to in co
match full-employment m e
GDP.
2. According to the Classical
theory, the loanable funds

n
io
pt
market acts as a conduit to

Ne
Saving
su
n
transfer spending power

Co

tt
axe
(S) from households to

s
borrowing units (firms and
government units).
3. Saving (S) is the “source”
of loanable funds.
1. To have a more secure future, to start a
business, to finance a child’s education,
to satisfy miserliness, . . .
2. To earn interest.
We view interest as
the “reward for
saving” or the “reward
for postponing
gratification.”
 The opportunity cost of
spending now (measured
Value of $1,000 in 3 years at in lost future spending) is
positively related to the
alternative interest rates interest rate.
Interest rate Future value
4% $1,127.27
5% $1,161.47
6% $1,196.68
7% $1,232.93
8% $1,270.24
9% $1,308.65
10% $1,348.18
11% $1,388.88
12% $1,430.77
 Supply of Funds
Saving = Supply
of Funds

Interest rate
5%

3%

0 1.5 1.75 Trillions of

Dollars
•To finance the acquisition of long-lived capital goods.
•The rate of interest is the cost of borrowing or the price of
loanable funds.
•The investment demand curve indicates the level of
investment spending at various interest rates.
•As the interest rate decreases, more investment projects
become attractive in the assessment of business decision-
makers—hence, the investment demand function is
downward-sloping with respect to the interest rate.
Demand for Funds
by Business When the interest rate falls,
investment spending and the
business borrowing needed
to finance it rises.
Interest rate

A
5%
B
3%
Investment
Demand

0 1.5
1.0 Trillions of
Dollars
 Level of Interest Rates

Factors that Risks of Securities

affect the Spending Needs
Supply the
Loanable Economic Condition
Funds Monetary Policy

Foreign Investors
Factors Interest Rates

that affect Demand for Funds

the Spending Needs

Demand Economic Condition

the
Monetary Policy
Loanable
Funds Foreign Participants
Public sector borrowing

Let G denote public sector (or government)

spending for goods and services in a year

T is net tax receipts in a year.

If G is greater than T, the the public sector has a

budget deficit equal to G – T.

If T is greater than G, then the public sector has a

surplus equal to T – G.

If the public sector has a budget deficit, it must

borrow.
 Public Sector Borrowing in Classica
G = $2 trillion
T = $1.25 trillion
Therefore,
Budget Deficit = G – T = $2 trillion - $1.25 trillion = $0.75 trillion
Government
Interest Rate Demand for Funds

5% B

3% A

0 0.75 Trillions of Dollars

 Demand for Loanable Funds (in Trillions)

[1] [2] [3] = [1] + [2]

Interest Rate Business Demand Government Demand Total Demand
5% 1.0 0.75 1.75
3% 1.5 0.75 2.25
 Total Demand
for Funds

Interest Rate
5%

3%

0 1.75 2.25 Trillions of Dollars

 Total Supply of
Funds (Saving)

Interest Rate
5 E
•Loanable Funds Market %
Equilibrium

Total Demand
for Funds
(Investment +
Deficit)
0
1.75 Trillions of Dollars
Why does the loanable funds theory
guarantee the validity of Say’s law?

S = IP + G - T

Quantity of Quantity of Funds

Funds Supplied Demanded

Now, rearrange the equation above by bringing T

to the left side:

S + T = IP + G

Injections
Leakages
 So long as the loanable
funds market “clears,”
leakages (Saving) will be
offset to injections
(investment and
government spending).
 Income
Income
($7 Trillion)
($7 Trillion)

Consumption
($4 Trillion) Saving ($1.75 Trillion)
Households
Net Taxes Loanable Funds
($1.25 Trillion) Markets
Government
Deficit
Spending ($2
($0.75
Trillion)
Trillion
Government
Goods Resource
Markets Markets
Investment
Firm Revenues ($1 Trillion)
($7 Trillion)

Firms Factor Payments

($7 Trillion)
• Changes in government
spending, transfer
payments, and taxes
designed to change total
spending in the economy
and thereby influence total
output and employment.
The Classical view
of Fiscal policy

•Friends, we believe that

fiscal policy is unnecessary
and ineffective. The
economy is doing just fine
without meddling by
Government.
•Crowding out is the idea that an
increase in one component of spending
will cause a decrease in other spending
components.
•An increase in G may cause a decrease
in C, IP, or both—that is, government
spending may “crowd out” private
spending.
 Crowding Out With an Initial Budget Deficit
Total Supply of
Funds (Saving)
7% B •Increase in G = AH
•Decrease in C = AC
A C •Decrease in IP =
H
Interest Rate
5% CH

D2 = IP +
G2 - T
D1 = IP +
G1 - T
0 1.75 2.05 2.25
Trillions of Dollars
 Effects of a Reduction in the Government Surplus

S2 = Savings + T – G2
S1 = Savings + T – G1
• G - Government Spending
• T - Net tax receipts in a
year

Interest Rate
• If G is greater than T, the 7% B
public sector has a budget
deficit equal to G – T.
H C
• If T is greater than G, then 5% A
the public sector has a
surplus equal to T – G.
• If the public sector has a
budget deficit, it must
borrow.

D = Investment

0 1.25 1.55 1.75 Trillions of Dollars