### Capital Markets

```Capital Markets
Chapter 24
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
\$1  i
\$1  i
Pt+1
1
1  rt 

\$1
Pt+1
Pt
Pt
1  it
1  rt 
 rt  it   t 1
1   t 1
Measuring the Real Interest Rate
•
1.
•
1.
Long-term
Use the yield on inflation protected securities.
Short-term
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
• Yield is equivalent to a real interest rate.
Real & Nominal Interest Rates
http://research.stlouisfed.org/fred2/categories/22
π10 Year Forecast
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)
r
DLF
SLF
r*
LF*
LF
Ex. Investment Boom in Emerging Markets
McKinsey Report
r
DLF
SLF
DLF'
r**
r*
2
1
LF*
LF**
LF
Ex. US Consumers become thriftier
r
DLF
SLF
SLF'
1
r*
r**
2
LF*
LF**
LF
Savings
• We divide savings into 2 parts:
SPrivate
+SPublic
= S
Private Saving
Public Saving/Government Saving
(Budget Surplus)
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).
Government Surplus
• Government surplus is gap between govt
revenue and spending and can be positive or
negative.
• If net positive, it adds to the supply of loanable
funds.
• If net negative, it adds to the demand for
loanable funds.
Example: Government strikes a deal to
raise taxes and cut spending
r
SLF
DLF
SLF'
1
r**
r*
2
LF*
LF**
LF
Ex.Japanese Government runs a deficit
Budget Plan
r
DLF
SLF
DLF'
2
r**
1
r*
LF*
LF**
LF
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.
http://www.bea.gov/national/nipaweb/SelectTable.asp?Selected=Y
Competitive Market Equilibrium:
Loanable Funds Market
r
SLF
DLF
r*
KA
LF*
LF
Investment Boom
[r Doesn’t Rise, Gap made up by Capital Inflows]
r
DLF
DLF' SLF
1
KA
2
rW
LF*
LF**
LF
Consumers become less thrifty
(r does not fall, gap made up by capital inflows)
r
DLF
SLF
1
rW
2
SLF'
KA
LF
Savings Glut
• Theory put forth by Fed Chairman explaining the U.S.
World Interest Rate Falls
(Global Economy)
r
DLF
SLF
rW
rW'
1
2
2
LF
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
1.00%
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
0.00%
-1.00%
-2.00%
-3.00%
-4.00%
-5.00%
-6.00%
-7.00%
NX
NFI
CA
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.
• Fisher Hypothesis: Ex ante real interest
rate is determined by forces in the
financial market. Money interest rate is
just the real ex ante rate plus the market’s
consensus forecast of inflation.
it  rt  
EA
FORECAST
t 1
Great Inflation of the 1970’s
US Inflation Rates & Interest Rates
18.00
16.00
14.00
%
12.00
10.00
Interest Rates
Inflation
8.00
6.00
4.00
2.00
Mar-03
Mar-00
Mar-97
Mar-94
Mar-91
Mar-88
Mar-85
Mar-82
Mar-79
Mar-76
Mar-73
Mar-70
Mar-67
Mar-64
Mar-61
Mar-58
Mar-55
0.00
Source: St. Louis Federal Reserve http://research.stlouisfed.org/fred2/
Fisher Effect:
OECD Economies Great Inflation of 1970’s
20
18
Interest Rates-1984
16
14
12
10
8
6
4
2
0
0
2
4
6
8
10
12
Average Inflation 1970-1984
14
16
18
Loanable Funds Market
Fisher Effect
DLF
SLF
i*
r*

 tE1
E
t 1
LF*
LF
Ex Ante vs. Ex post
• We can also examine the ex post real return
on a loan as the money interest rate less the
actual outcome for inflation.
ExP
ACTUAL
t
t
t 1
 i 
r
• The gap between actual and forecast inflation
determines the gap between the ex post
(actual) and ex ante (forecast) return.
rt
ExP
 rt
ExA

FORECAST
t 1

ACTUAL
t 1
Unexpected Inflation
Winners and Losers
▫ Higher than expected inflation means ex
post real rates are lower than ex ante.
Borrowers are winners/lenders are
losers.
▫ Lower than expected inflation means ex
post real rates are higher than ex ante.
Lenders are winners/borrowers are
losers.
Inflation Risk
• When inflation is variable, lenders will
demand some premium for inflation risk.
This will put cost on borrowers.
• High inflation rates tend to be associated
with unpredictable inflation.
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.
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