Chapter 4 : The level of Interest Rate

Prepared by A. Al Mannaei
 What is Interest Rate ?
Mariam deposit 20,000 BD in Kuwait Finance House as
a fixed deposit, the bank inform her that the interest
rate is 5% ?

If the bank increase the Interest rate to 10% ?!

Mariam will Better-off OR worse-off ?!

From Mariam – investor - point of view, what is Interest

Rate ?
What is Interest Rate ?
Interest rate for investor is :
– Return for investment.

– If interest rate increase >> make higher return!

• Therefore, investor is willing to invest more*.

– If interest rate decrease>> make lower return!

• Therefore, investor will invest less*.

*refer to graph in slide 7.

 What is Interest Rate ?
Sara take 20,000 BD from Kuwait Finance House as a
personal loan, the bank inform her that the interest rate is
5% ?

If the bank increase the Interest rate to 10% ?

Sara will Better-off* OR worse-off ?!

From Sara point of view, what is Interest Rate ?

* Making more money

What is Interest Rate ?
• Interest rate for borrower is :
– Cost of borrowing.

– If interest rate increase >> more cost!

• Therefore, borrower will borrow less*.

– If interest rate decrease>> lower cost!

• Therefore, borrower will borrow more*.

*refer to graph in slide 8.

What is Interest Rate ?
• What is Interest Rate ?
– Rental Price of Money.
– Cost of borrowing.
• (Penalty to borrowers for consuming before earning).
– Return for investment
• (Reward for savers for saving).

 If interest rate changes (increase or decrease)

it will affect ________&________ .
 Loanable Fund Theory
Supplier of loan*

* = Supplier of loanable fund

 Loanable Fund Theory
Demander of loan*

* = Demander of loanable fund

Loanable Fund Theory
• If IR Increase
– Lenders (SL) willing to lend more
• (Quantity of supply increase)
– Borrowers (DL) will borrow less
• (Quantity of demand decrease)
• If IR Decrease
– Lenders (SL) will lend less
• (Quantity of supply decrease)
– Borrowers (DL) willing to borrow more
• (Quantity of demand increase)
Loanable Fund Theory
Loanable Fund Theory
Loanable Fund Theory

What if Demand :

Increase >> IR &Q

Decrease >> IR &Q

Loanable Fund Theory

What if Supply:

Increase >> IR &Q

Decrease >> IR &Q

Loanable Fund Theory

What happen to IR if: IR

Individual Tax decrease

Government deficit
increase
Increase in productivity

Increase in money supply

 Inflation
• The rate at which the general level of prices
for goods and services is rising, and,
subsequently, purchasing power is falling.
• Simply mean, money worth less than before
!
 Inflation
• Rawan bought a car for 5000 BD, after a
year her sister want to buy the same car,
the salesman inform her that the current
price is 5100 BD .
• The inflation increased by 2%.
> It mean value of money decline by 2%!
Real & Realized
• Real IR take into account inflation effect

Real IR = Nominal – Expected inflation*

Realized IR = Nominal – Actual inflation*

* Simplified Fisher equation

 Real & Realized Interest Rate
Sara would like to invest 1000 BD today ( Jan
2015), the bank offer here 5%, the expected
inflation is 3%

Calculate her return (Real IR) ?

 Real & Realized
Continue ..
At Maturity (Jan 2016 ) she recognized that the
inflation in 2015 was 2% .

Calculate her return (Realized IR) ?

Do you think sara is better off because inflation
was lower than she expect ?
Real & Realized
Example : If you invest 1000 BD , the bank offer
you 3% , the expected inflation is 2% , at maturity
the inflation was 1% ?
• What is the Nominal interest rate ?
• What is your Real interest rate ?
• What is Realized interest rate ?
• Who will benefit because of actual inflation < expected
inflation ?
Test Your knowledge
Real IR = Nominal – Expected inflation
Realized IR = Nominal – Actual inflation
•In which case :
– Real IR = Nominal ?
– Real = Realized IR ?
– Real > Realized ?
– Realized will be in negative ?

 What is relationship between Real/ized IR & A/E

Inflation ?
Real & Realized
There is three scenarios for real & realized rate :
– Pa > Pe
• Lender earn lower
• Borrower benefit
• ( Purchasing power goes to Borrower)
– Pa < Pe
• Lender earn Higher
• Borrower worse-off
• ( Purchasing power goes to Lender)
– Pa = Pe
• ( No transfer of Purchasing power )
Fisher Equation
• According to fisher equation , lender
should be compensated for inflation .

Fisher Equation : nominal rates include the

real rate of interest plus expected annual
inflation rates.

Fisher = Nominal + Expected inflation

Test Your knowledge
Fisher Equation
Question
• 1-year $1000 loan
• Parties agree on 3% real rate for money and
• 5% expected rate of inflation.

– Items to pay Calculation Amount

– Principal
– Rent on money
– PP loss on principal
– PP loss on interest
– Total Compensation
Exercise
• An investor loaned $4500 at nominal
interest rate of 20% , expected rate of
inflation is 10% . After a year the actual
inflation was 12%.
• Calculate:
– Real ( expected ) IR ?
– Realized Real IR ?
– Which party will benefit because of actual
inflation is higher than expected inflation ?
Exercise
Exercise (Continue)

An investor loaned $4500 at nominal interest

rate of 20% , expected rate of inflation is 10% .
After a year the actual inflation was 12%.
What is the total compensation of the lender?
Items to pay Calculation
Amount
–Principal
–Rent on money
–PP loss on principal
–PP loss on interest
–Total Compensation
Exercise T&F
• The expected real rate of interest is likely to be
negative.

• An increase in desired investment shifts the

desired savings supply line upward to higher real
rates of interest.
Exercise T&F
• An upward shift in the supply of loanable
funds is likely to increase interest rates.
Exercise
What is the gap between 3-month T-bill rate
& Realized IR ?
Exercise T&F
• Deficit spending units supply loanable
funds.
Exercise T&F
• If yields on thirty-year U. S. Treasury bonds
are 8% and the real rate of interest is
estimated at 3%, the historical rate of
inflation is 5%.
Hint:
Real IR = Nominal – Expected inflation*

Realized IR = Nominal – Actual inflation*

Exercise
• Nominal rates generally exceed the real
rate.

• Short-term rates are more responsive to

changes in inflation than long-term rates.
 Thank You

Kingsoft Office
ublished by www.Kingsoftstore.com @Kingsoft_Office

kingsoftstore