Module: Money & Banking

Topic: Interest Rates

Chapter 7
Interest Rates

Modern Money and

Banking by Roger
Leroy Miller
Lecture Objectives

This lecturer aims:

To understand how is the market rate of

interest determined?
What is the economic function of the

interest rate?
What is the difference between real and

nominal interest rates?

Interest and the Interest Rate
 interest is the amount of funds, valued in terms of
money, that lenders receive when they extend credit;
the interest rate is the ratio of interest to the amount
lent.
 There are further reasons that credit markets arise:
1. Different households have different personalities—
they have different preferences for present versus
future consumption
2. Businesses can make investments in plant,
equipment, and/or inventory that are profitable
enough to enable them to pay back interest
Determination of the Market Rate of
Interest
 In the simplest model, the market rate of interest is
established at the intersection of the supply of and the
demand for credit, or loanable funds.
 The demand for loanable funds consists of the
demand for consumer loans (consumption) and
business loans (investment); each varies inversely as
the rate of interest rises or falls.
 The supply of loanable funds consists mostly of
household saving: it varies directly with the rate of
interest.
Nominal Versus Real Interest Rates

 A nominal interest rate is defined as the rate of

exchange between a dollar today and a dollar at some
future time.
 For example, if the market, or nominal, rate of interest
is 10 percent per year, then a dollar today can be
exchanged for $1.10 one year from now.
 The real interest rate, on the other hand, is the rate of exchange
between goods and services (real things) today and goods and
services at some future date.
 In a world of no inflation or deflation, the nominal rate of interest
is equal to the real rate of interest.
 A 10 percent annual rate of interest with no inflation guarantees a
rate of exchange of $1.00 in money terms with $1.10 in money
terms a year from now, and vice versa.
 Because, in our hypothetical example, there is no inflation in real
terms (purchasing-power terms), the rate of exchange is between
$1.00 of real goods and services today and $1.10 of real goods
and services a year from now.
 But what about a world in which inflation (or deflation) is
anticipated? Assume that everyone anticipates a 10 percent
annual rate of inflation, and leave aside the complications of
taxes. A nominal rate of interest of 10 percent per year will still
mean that the rate of exchange between dollars today and
dollars a year from now is 1 to 1.1.
 But $1.10 in dollar terms a year from now will buy only $1.00
worth of the goods and services that can be purchased today. If
everyone anticipates a 10 percent annual inflation rate, then in
real terms the 10 percent annual nominal rate of interest
effectively means a zero real rate of interest
An Equation Relating Real and Nominal
Interest Rates

The relationship between the nominal rate of interest

and the real rate of interest can be shown as an
equation, given by

Nominal rate = real rate of interest + expected rate of inflation +

(real rate of interest * expected rate of inflation )
 In normal times, the product in the parentheses is
small enough to be ignored (for instance, if the real
interest rate is 0.03 and the expected rate of inflation
is 0.06. the value of the term would be equal to
0.0018, which is less than one-fourth of 1 percent).
 It cannot, of course, be ignored in times of high
inflation such as hyperinflations.
 Assuming that interest rates and inflation rates are
relatively small, however, it is safe to simplify by
abstracting from the product in parentheses, in which
the equation for the nominal interest rate is
Nominal rate of interest= real rate of interest + expected
rate of inflation

This equation can be rearranged to show that

Real rate of interest = nominal rate of interest -expected

rate of inflation
 The distinction between nominal and
real rates of interest, which was first
clarified by the American economist
Irving Fisher (1867-1947), is crucial in a
world of inflation and expected inflation
when trying to predict household and
business behavior, as later chapters will
emphasize.
Different Types of Nominal Interest
Rates
 Every lending market has its own interest rate. There
is a mortgage market, a short-term business loan
market, and a government securities market. For
every type of market lending instrument—such as a
government bond or a mortgage—there is a particular
interest rate.
 In the sections that follow, some of the most important
interest rates are discussed.
The Prime Rate
 Perhaps the most frequently quoted interest rate is the
prime rate. This is the rate that banks charge on short-
term loans made to large corporations with impeccable
financial credentials—their "most creditworthy
customers," as the newspapers refer to them. (KIBOR)
 The published prime rate is typically the lowest interest
rate that such creditworthy businesses pay for short-
term loans. Such business transactions are
characterized by relatively little default or credit risk.
 Fewer expenses are incurred by the lending bank to
investigate the creditworthiness of the borrowing
company.
The Corporate Bond Rate
 Another important interest rate is the one paid on
high-grade (low-risk) corporate bonds.
 Suppose that a corporation such as International
Chemical Corporation (ICC) wants to expand its
production facilities and must borrow money to do
this.
 One way to raise that money is to borrow it by issuing
ICC corporate bonds.
 ICC sells these bonds for. say, $1,000 apiece and
agrees to pay back the principal to the lenders at the
end of 10 years.
The Corporate Bond Rate (Cont’d)

 During those years, ICC also promises to pay annual

interest on the loan.
 That annual interest payment, divided by the price of
the bond, is the corporate bond rate.
 Different corporations borrow at different bond rates,
depending on the financial soundness
(creditworthiness) of the institution backing the rate.
Bond Rating Services

 Risk ratings for corporate (and state and local

government) bonds are provided b> Moody's
Investors Service and Standard & Poor's Corporation.
 The Moody's ratings consist of nine different classes
or grades, ranging from Aaa (best quality), to Baa
(lower-medium quality), to Caa (poor standing), to C
(extremely poor prospect).
 The ratings are based on detailed studies designed to
assess the financial soundness of a particular
corporation (or government) to determine how risky its
bonds are for investors.
Bond Rating Services (Cont’d)

 More precisely, the studies are designed to assess

the ability of a government or corporation to make its
interest and principal payments on schedule.
 Each corporate issue is given a particular rating.
 Published corporate bond rates are usually given only
for the highest-grade bonds those that are rated Aaa
by Moody's (or AAA by Standard & Poor's).
The Federal Funds Rate
 The federal funds rate is the rate at which depositor
institutions borrow and lend reserves in the federal
funds market, the market for interbank lending we
touched on in Chapters 5 and 6.
 In fact, there is no single "federal funds rate": the
federal funds rate reported daily in the Wall Street
Journal and other news sources really is an average
 of rates across institutions.
 Different depository institutions typically pay different
rates to borrow or lend federal funds, a phenomenon
known as tiering of the federal funds rate.
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