Chapter 2-3 Assessment

1. How does Fisher Effect affect the market interest rate?

The Fisher effect affirms that in response to a shift in the money supply the
nominal interest rate changes in tandem with changes in the inflation rate in the long run.
For instance, if monetary policy were to cause inflation to increase by five percentage
points, the nominal interest rate in the economy would also increase by five percentage
points.

Moreover, it is essential to keep in mind that the Fisher effect is a phenomenon

that develops in the long run, but that may not be present in the short run. In other words,
nominal interest rates do not directly jump when inflation changes, principally because
several loans have fixed nominal interest rates, and these interest rates were set based on
the expected level of inflation. If there is unanticipated inflation, real interest rates can
fall in the short run because nominal interest rates are fixed to some degree. Over time,
however, the nominal interest rate will adapt to match up with the new expectation of
inflation. Hence, it is vital to understand the concepts of nominal and real interest rates.
That is because the Fisher effect means that the real interest rate equals the nominal
interest rate less the expected rate of inflation.

In this case, real interest rates happen as inflation increases unless nominal rates
increase at the same rate as inflation. Indeed, the Fisher effect asserts that nominal
interest rates conform to changes in expected inflation.

2. How is the market interest rate in the short-term and long-term financial market
affected under the Pure Expectations theory when suppliers and users of loanable
funds expect that interest rates will decrease the next year?

Expectation’s theory attempts to forecast short term interest rates based on the
current long-term rates by assuming no arbitrage opportunity and therefore implying that
two investment strategies spread in a similar time horizon should yield an equal amount
of returns. For example, Investment in bonds for two consecutive one-year bonds yields
the same interest as investing in a two-year bond today. Likewise, if it will decrease the
next year. Because it basically assists the investors to foresee the future interest rates and
also assist in the investment decision making. The assumption of this theory is that
forward rates represent the upcoming future rates. In a way, it gives a fair understanding
of the interest rates to the investors willing to invest in any type of bonds, short term or
long term.
3. How does the Liquidity Premium Theory influence the market interest rate?

The liquidity premium theory (LPT) is a viewpoint of both the expectancy theory
(ET) and the segmented markets theory (SMT). LPT is a combination of both ideas on
bonds, maturities, and their corresponding effects on yields. It employs insights from
both to explain the common phenomenon of long-term yields being higher than short-
term yields. The explanation is simple. The economy needs long-term bonds as well as
short-term ones. Investing in long-term bonds is far more complicated because of
uncertainty that the longer the term, the more uncertain the outcomes. Therefore, since
long-term bondholders keep their money tied up longer, they miss other short-term
opportunities and face more uncertainty.

LPT serves as a market mechanism to encourage equilibrium between long- and

short-term bondholders. This theory stresses that while the two types of bonds are very
similar, they are not identical. LPT predicts that even if interest rates are predicted to be
flat, long-term bonds will still yield higher profits at the end of their term. If long-term
rates are expected to drop, then long-term investors can expect to break even, or even
make a tidy profit. LPT serves to explain how this can be.

4. What are the different factors that affect the interest rates set by issuers of debt
securities? 

An interest rate is the cost of borrowing money. The interest provides a reliable
compensation for bearing risk. Interest rate levels are a factor in the supply and demand
of credit. The interest rate for various types of loan depends on factors which are the
credit risk, time, tax considerations, and convertibility of the particular loan.