Estimate the real interest rate over the last year. If financial market participants overestimate inflation in a particular period, will real interest rates be relatively high or low? If inflation is overestimated, the real interest rate will be relatively high. Investors had required a relatively high nominal interest rate because they expected inflation to be high according to the Fisher effect. Forecasting Interest Rates. Why do forecasts of interest rates differ among experts?
ANSWER: Various factors may influence interest rates, and changes in these factors will affect interest rate movements. Experts disagree about how various factors will change. They also disagree about the specific influence these factors have on interest rates. Advanced Questions Impact of Stock Market Crises.
During periods when investors suddenly become fearful that stocks are overvalued, they dump their stocks, and the stock market experiences a major decline. During these periods, interest rates also tend to decline. Use the loanable funds framework discussed in this chapter to explain how the massive selling of stocks leads to lower interest rates.
ANSWER: When investors shift funds out of stocks, they move it into money market securities, causing an increase in the supply of loanable funds, and lower interest rates. Impact of Expected Inflation. How might expectations of higher global oil prices affect the demand for loanable funds, the supply of loanable funds, and interest rates in the United States?
Will this affect the interest rates of other countries in the same way? Since higher inflation can increase interest rates, it will cause an expectation of higher interest rates in the U. Firms and government agencies may borrow more funds now before prices increase and before interest rates increase.
Consumers may use their savings now to buy products before the prices increase. Therefore, the demand for loanable funds should increase, the supply of loanable funds should decrease, and interest rates should increase in the U. If the country produces its own oil, it can set the oil prices in its country. If it can prevent high oil prices in its country, then the prices of products gasoline and services transportation may not be affected. Therefore, interest rates may not be affected.
Global Interaction of Interest Rates. Why might you expect interest rate movements of various industrialized countries to be more highly correlated in recent years than in earlier years? ANSWER: Interest rates among countries are expected to be more highly correlated in recent years because financial markets are more geographically integrated.
More international financial flows will occur to capitalize on higher interest rates in foreign countries, which affects the supply and demand conditions in each market.
The international flow of funds caused this type of reaction. Impact of War. War tends to cause significant reactions in financial markets. Why might a war in the Middle East place upward pressure on U. Why might some investors expect a war like this to place downward pressure on U.
However, it may also cause some analysts to revise their forecasts of economic growth downward. The slower economy reflects a reduced corporate demand for funds, which by itself places downward pressure on interest rates. If inflation was not a concern, the Fed may attempt to increase money supply growth to stimulate the economy. However, the inflationary pressure can restrict the Fed from increasing the money supply to stimulate the economy since any stimulative policy could cause higher inflation.
Impact of September Offer an argument for why the terrorist attack on the United States on September 11, could have placed downward pressure on U.
Offer an argument for why that attack could have placed upward pressure on U. ANSWER: The terrorist attack could cause a reduction in spending related to travel airlines, hotels , and would also reduce the expansion by those types of firms. This reflects a decline in the demand for loanable funds, and places downward pressure on interest rates. Conversely, the attack increases the amount of government borrowing needed to support a war, and therefore places upward pressure on interest rates.
Jayhawk Forecasting Services analyzed several factors that could affect interest rates in the future. Most factors were expected to place downward pressure on interest rates.
Jayhawk also expected that although the annual budget deficit was to be cut by 40 percent from the previous year, it would still be very large. Thus, there should be additional funds available to satisfy other borrowing needs. Given this situation plus the other information, Jayhawk should have forecasted lower interest rates. Decomposing Interest Rate Movements. The interest rate on a one-year loan can be decomposed into a one-year risk-free free from default risk component and a risk premium that reflects the potential for default on the loan in that year.
A change in economic conditions can affect the risk-free rate and the risk premium. The risk-free rate is normally affected by changing economic conditions to a greater degree than the risk premium. Explain how a weaker economy will likely affect the risk-free component, the risk premium, and the overall cost of a one-year loan obtained by a the Treasury, and b a corporation. Will the change in the cost of borrowing be more pronounced for the Treasury or for the corporation?
The overall cost of borrowing is reduced for a loan to the Treasury and a loan to a corporation. There is a partial offsetting effect on the interest rate of the loan to the corporation. However, the Treasury does not have risk of default so there is no effect on the risk premium on a loan to the Treasury. The weaker economy will have a more pronounced impact on the interest rate of the loan to the Treasury, because there is no offsetting effect.
Based on these conditions, do you think interest rates will likely increase or decrease during this semester? Offer some logic to support your answer. Which factor do you think will have the greatest impact on interest rates? It requires students to apply the concepts that were presented in this chapter in order to develop their own view.
This question can be useful for class discussion because it will likely lead to a variety of answers, which reflects the dispersed opinions of market participants. Impact of Economic Crises on Interest Rates. When economic crises in countries are due to a weak economy, local interest rates tend to be very low. However, if the crisis was caused by an unusually high rate of inflation, interest rates tend to be very high. Explain why. ANSWER: A weak economy causes a reduction in the demand for loanable funds, because corporations reduce their expansion plans as they anticipate a reduced demand for their products.
The reduced demand for loanable funds results in lower interest rates. However, if a crisis is caused by high inflation, corporations and households engage in heavy borrowing and spending before prices rise further.
Thus, the strong demand for loanable funds places upward pressure on interest rates. Interest Rates During the Credit Crisis. During the credit crisis, U. Holding other factors constant, this should result in a higher number of feasible projects, which should encourage businesses to borrow more money and expand. Yet, many businesses that had access to loanable funds were unwilling to borrow during the credit crisis. What other factor changed during this period that more than offset the potentially favorable effect of the low interest rates on project feasibility, therefore discouraging businesses from expanding?
ANSWER: Businesses recognized that the cash flows to be generated from their projects would be low because the demand for their products and services was limited. Households could not afford to purchase more products. Thus, while low interest rates allow businesses to borrow funds cheap, many possible projects were not feasible because the expected cash flows were not sufficient.
Political Influence on Interest Rates. Offer an argument for why a political regime that favors a large government will cause interest rates to be higher. Offer at least one example of why a political regime that favors a large government will cause interest rates to be lower [Hint: Recognize that the government intervention in the economy can influence other factors that affect interest rates.
Assuming that taxes are not affected, the fiscal budget deficit will be larger. As the government borrows more to cover the fiscal budget deficit, it increases the demand for loanable funds, and this causes interest rates to be higher. For example, if the economic conditions are improved as a result of the government programs, this might result in more income to households and lower income, and lower unemployment lower unemployment compensation paid by the government.
Under these conditions, a larger government will not necessarily result in a larger fiscal budget deficit. Impact of Stock Market Uncertainty. Consider a period in which stock prices are very high, such that investors begin to think that stocks are overvalued and their valuations are very uncertain. If investors decide to move their money into much safer investments, how do you think this would affect general interest rate levels? In your answer, use the loanable funds framework by explaining how the supply or demand for loanable funds would be affected by the investor actions, and how this force would affect interest rates.
This results in an increase in the supply of loanable funds, which places downward pressure on interest rates. Impact of the European Economy. Use the loanable funds framework to explain how European economic conditions might affect U.
If the European economy causes economic conditions in the U. In addition, the weak European economy might cause European firms to borrow fewer funds from the U. Either of the forces explained here reflect a decline in the demand for loanable funds, which places downward pressure on interest rates.
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