Topic 2 Interest rates and Inter

est rate policies

 Credit
• Definition of Credit
Credit in economics refers to the behavior of
borrowing and lending with the feature of
repayment of the principals plus interests
and is a special form of movement of value,
concretely the owner of commodity or
money lends it to the demanders or
borrowers who promise to repay the lender
with interests at a certain time in the future.
 Nature of Credit
• Credit is the behavior of borrowing and
lending with the condition of repayment of
principals with interests.
• The relationship of credit is that between
creditors and debtors.
• Credit is a special form of movement of
value.
 Features of Credit
• Temporization
• Repayment
• Profitability
• Risk
 Forms of Credit
• Commercial credit
Commercial credit is the credit that is
provided mutually between enterprises and
is linked directly to goods exchange.
• Banker’s credit
Banker’s credit is the credit that is granted
by banks and other financial institutions.
(The credit provided by banks)
 Forms of Credit
• Public credit
Is the credit in which governments at all levels are
the principal parts of borrowing and lending
activities.
• Consumer’s credit
Consumer’s credit or consumption credit is the
credit that businesses, banks and other financial
institutions grant to consumers for meeting
consumers’ demand for consumer goods.
 Forms of Credit
• Private credit
Private credit is the credit granted mutually
between individuals in the form of money or
goods.
 Questions
• What is credit?
• Can you list some examples?
 Interest
• Interest is the remuneration paid by a
borrower to a lender in credit.
 Interest Rates
• Interest rates are among the most closely
watched variables in the economy. Their
movements are reported almost daily by the
news media because they directly affect our
everyday lives and have important
consequences for the health of the economy.
 Interest Rates
• They affect personal decisions such as
whether to consume or save, whether to buy
a house, and whether to purchase bonds or
put funds into a saving account. Interest
rates also affect the economic decisions of
businesses and households, such as whether
to use their funds to invest in new
equipment for factories or to save their
money in a bank.
 Interest and Interest Rates

• Interest and interest rate are two basic

categories coming with the concept of
credit.
• What we mainly should learn from interest
rate theories is how to determine the
interest rate.
• Essence of Interest
• Types of Interest Rates
• Calculation of Interest
• Determinants of Interest Rates
• Functions of Interest Rates
• The Structure of Interest Rates
• Interest Rate Policies
 Essence of Interest
• The fee charged by a lender to a
borrower for the use of borrowed
money, usually expressed as an
annual percentage of the principal
 Theories about Interest
• Austrian Interest Theory
Interest is derived from value differences
between goods in present and goods in
the future.
Basically, consumers have two choices for
their earnings. Consume now or consu
me later.
Interest is a product of time preference.
• Marx ＇ s Interest Theory
Interest actually is a part of profit, a special f
orm of converted surplus value

Interest is the foundation of credit relationshi

p
 What is Interest Rate?

• The interest rate is the yearly price

charged by a lender to a borrower
in order for the borrower to obtain
a loan. This is usually expressed as
a percentage of the total amount
loaned
 Types of Interest Rate
• Average interest rate and basis interest rate
AR usually is for theoretical analysis
BR is the foundation of all other kinds of
interest rate
• Fixed rate and floating rate
FR doesn’t change during the loan term, easy
for calculating cost and profit
FLR changes during the loan term under certain
conditions, usually half year once.
 Types of Interest Rate
• The market interest rate and official interest
rate
Set by different parties, market or government
• General interest rate and prime interest rate
Different loan objects, Discount Government
Loan
• Nominal interest rate and real interest rate
Inflation
 Inflation
• The interest rate that is adjusted by
subtracting expected changes in the price
level so that it more accurately reflects
the true cost of borrowing.
 Inflation
• When the amount of money circulating
grows faster than the rate at which goods
and services are produced, the result is
inflation.
• inflation—too much money chasing too few
goods.
• Hyperinflation——a rapid rise in prices that
seriously damages a country’s economy.
 Inflation

• It creates an inefficient price system

• It also distorts decision-making,
reduces productivity and lowers the
economy's long-term rate of growth.
• It results in lower living standards for
everyone
 Inflation
• The real interest rate is more accurately
defined by the Fisher equation. It states that
the nominal interest rate i equals the real
interest rate I plus the expected rate of
inflation X .
• The real interest rate is likely to be a better
indicator of the incentives to borrow and lend.
When the real interest rate is low, there are
greater incentives to borrow and fewer
incentives to lend.
 Roles of Interest Rates
• Interest rates and economic accounting

As the cost of funds, interest rates directly

affect economic efficiency of enterprises.

Banks can raise the efficiency of the fund use

by charging different borrowers different
interest rates.
 Roles of Interest Rates
• Interest rates and savings

Interest rates affect savings and

consumption oppositely.
 Roles of Interest Rates
• Interest rates and investment

As for capital investment, low interest rates

stimulate investment, while higher interest
rates hinder the expansion of investment.

What about for portfolio investment?

 Roles of Interest Rates
• Basis for rent calculation

The measurement of rent is influenced by

many factors, such as traditional customs
and habits, government’s regulation,
demand and supply of items to be rented.
The rent is usually determined with the
reference to the interest rate.
 Roles of Interest Rates
• Interest rates and inflation

Interest rates are used to regulate the

aggregate demand and supply.

Interest rates are used to regulate the

quantity of the money supply.
 Roles of Interest Rates
• Interest rates and economic regulation
To better the structure of industires
To gather idle funds to satisfy the fund
demand
To regulate money circulation
To balance a country’s external balance of
payments
 Calculation of Interest
• Single Interest
No matter how long the loan term is, interest
only will be calculated based on the
principal, not including the interest occurred
at the end of each term period.
For example, principal is $1000, interest rate is
10% per year, loan term is 3 year.
So at the end of third year, what is the sum of
principal and interest?
 Calculation of Interest
• Formulas for single interest
calculation
• R=P * r * n (R is interest, P is
principal, r is interest rate, n is the
number of year)
• F=P(1+rn)
 Calculation of Interest
• Compound Interest
Interest which is calculated not only on the
initial principal but also the accumulated
interest of prior periods
For example, principal is $1000, interest rate is
10% per year, loan term is 3 year
So at the end of third year, what is the sum of
principal and interest?
 Calculation of Interest
• Formulas for compound interest
calculation
• R=P[(1+r)n-1] (R is interest, P is
principal, r is interest rate, n is the
number of year)
• F=P(1+r)n
Which type of interest does
more efficiently reflect the
essence of interest?
 Present Value and Future Value

• The concept of present value is based on the

common sense notion that a dollar of cash
flow paid to you one year from now is less
valuable to you than a dollar paid to you
today.
• Simple loan
 Present Value and Future Value

• The sum of principal and interest which

uses compound interest to compute is
called future value. By its converse
calculation, the principal, namely present
value, also could be figured out with the
future value and interest rate.
• Both those two concepts have very extensive
usage in the real life, such as amortization
and retirement pension.
 Exercise
• Suppose you put your salaries at the en
d of each month with $100 into bank, an
d you planned to keep saving for 10 yea
rs with an annual interest rate of 12%.
So if you will get retire at the end of 10th
year, how much money could you get b
ack from bank?
R=P*r*n(n+1)/2 Single interest 19260
 Exercise
• Suppose you put $1000 at the beginning of
every year into bank for 10 years long. The
annual compound interest rate is 12%.
So how much could you get back from bank
at the end of 10th year?
F=P[(1+r)n+1-1-r]/r Compound interest rate
19658
 Exercise

• Suppose you put $10000 into bank at th

e beginning of first year. With an annu
al compound interest rate 15%, what is
maximum amount of money that you c
an take out from bank within 3 years?
• A=P[r(1+r)n]/[(1+r)n-1]
Compound interest rate 4379.8
 Exercise
• If you want to ensure that you can have at
least $60000 each year after retirement bet
ween 60 to 80 years old with an annual co
mpound interest rate 10%. Also we suppo
se you attend to work from 20 years old,
what is minimum salary level of each year
with an annual compound interest rate 15
%?
 Exercise
• Now you have two choices by investing on
a project. Plan A is to spend 500 million dol
lars in year 1, 200 million dollars both in ye
ar 2 and 3. Plan B is to invest 100 million do
llars in year 1, 300 in year 2, 600 in year 3.
• With an annual interst rate of 15%, which p
lan could help lower the cost?
• A=500+(200/1+15%)+(200/1.15*1.15)=825
• B=100+(300/1+15%)+(600/1.15*1.15)=815
 Review
• Now you have two choices by investing on a
project. Plan A is to spend 300 million
dollars in year 1, 100 million dollars both in
year 2 and 3. Plan B is to invest 100 million
dollars in year 1, 100 in year 2, 300 in year 3.
• With an annual interst rate of 15%, which pl
an could help lower the cost?
 Determinants of Interest Rates

• Classic Interest Rate Theory

• Liquidity Preference
• The Theory of Loadable Funds
• Other factors including economy
cycle, fiscal policies, government
power
 Classic Interest Rate Theory

• It believes that interest rates are

determined by interaction of savings
and investment.
• Investment is negative related to
interest rates.
• Savings is positive related to interest
rates.
 Liquidity Preference
• Liquidity preference in macroeconomic
theory refers to the demand for money,
considered as liquidity. The concept was
first developed by John Maynard Keynes in
his book The General Theory of Employment,
Interest and Money (1936) to explain
determination of the interest rate by the
supply and demand for money.
 Liquidity Preference
• According to Keynes, demand for liquidity
is determined by three motives:
• The transactions motive: people prefer to
have liquidity to assure basical transactions,
for their income is not constantly available.
The amount of liquidity demanded is
determined by the level of income: the
higher income, the more money demanded
for carrying out increased spending.
 Liquidity Preference
• The precautionary motive: people prefer to
have liquidity in the case of social
unexpected problems that need unusual
costs. The amount of money demanded also
grows with the income.
 Liquidity Preference
• Speculative motive: people retain liquidity
to speculate that bond prices will fall. When
the interest rate decreases, people demand
more money, to hold until the interest rate
increases, which would drive down the
price of an existing bond to keep its yield in
line with the interest rate. Thus, the lower
the interest rate, the more amount of money
demanded (and vice versa).
 The Theory of Loadable Funds

• It states that interest rates are decided by

demand and supply of loadable funds,
instead of savings and investment.
• The interest rates are paramount important
in this process for the following reasons: 1.
because it is the reward for lending and the
cost of borrowing, then influences the
behavior of net borrowers and lenders; 2.this
behavior also counteracts the interest rate.
 The Theory of Loadable Funds

• The demand for loadable funds originates

from the household, business, government,
and foreign net borrowers who borrow
because they are spending more than their
current income. The downward-sloping
demand curve indicates that net borrowers
are willing to borrow more at lower interest
rate.
 The Theory of Loadable Funds

• The total supply of loadable funds originates

from two basic sources: 1.the household,
business, government, and foreign net lenders
who are prepared to lend because they are
spending less than their current income; 2.the
central bank, which, in its ongoing attempts to
manage the economy’s performance, supplies
reserves to the financial system that lead to
increases in the growth rate of money.
 Functions of Interest Rate

• Influence on Money Demand

• Influence on Money Supply
• Influence on Central Bank Monetary
Policies
• Influence on Exchange Rate
• Influence on the Price of Financial
Assets
 Money multiplier

• The most common mechanism used to

measure this increase in the money supply is
typically called the money multiplier. It
calculates the maximum amount of money
that an initial deposit can be expanded to
with a given reserve ratio.
Comparing Treasure Bill
and Corporation
Think about… Bond
with same term, which
one’s interest rate is
higher?
• T-Bill: A negotiable debt obligation issued
by the U.S. government and backed by its
full faith and credit, having a maturity of
one year or less. Exempt from state and local
taxes.
• Corporation Bond: A type of bond issued by
a corporation
• In our supply and demand analysis of
interest-rate behavior in previous section,
we examined the determination of just one
interest rate. Yet we saw earlier that there
are enormous numbers of bonds on which
the interest rates can and do differ.
• We first look at why bonds with the same
term to maturity have different interest
rates. The relationship among these interest
rates is called the risk structure of interest
rates, although risk, liquidity, and income
tax rules all play a role in determining the
risk structure.
• A bond’s term to maturity also affects its
interest rate, and the relationship among
interest rates on bonds with different terms
to maturity is called the term structure of
interest rates. In this section we examine
how risk and term structure cause
fluctuations in interest rates relative to one
another and look at a number of theories
that explain these fluctuations.
 Structure of Interest Rate

• Risk Structure
Default Risk
It occurs when the issuer of the bond is
unable or unwilling to make interest
payments when promised or pay off
the face value when the bond matures
• A corporation suffering big losses, such as
Chrysler Corporation did in the 1970s, might
be more likely to suspend interest payments
on its bonds. The default risk on its bonds
would therefore be quite high.
• By contrast, U.S. Treasury bonds have
usually been considered to have no
default risk because the federal
government can always increase taxes to
pay off its obligations. Bonds like these
with no default risk are called default-free
bonds.
 Structure of Interest Rate
Risk Premium
The spread between the interest rates on bonds
with default risk and default-free bonds.
It indicates how much additional interest
people must earn in order to be willing to
hold that risky bond.
A bond with default risk always has a positive
risk premium and the higher the default risk
is, the larger the risk premium will be.
 Structure of Interest Rate
• Because default risk is so important to the
size of the risk premium, purchasers of
bonds need to know whether a corporation
is likely to default on its bonds.
• This information is provided by credit-
rating agencies, investment advisory firms
that rate the quality of corporate and
municipal bonds in terms of the probability
default.
 Structure of Interest Rate

Liquidity Risk
A liquid asset is one that can be
quickly and cheaply converted
into cash if the need arises
The more liquid an asset is, the
more desirable it is.
 Structure of Interest Rate
• U.S. Treasury bonds are the most liquid of
all long-term bonds because they are so
widely traded that they are the easiest to sell
quickly and the cost of selling them is low.
• Corporate bonds are not as liquid because
fewer bonds for any one corporation are
traded, thus it can be costly to sell these
bonds in an emergency because it may be
hard to find buyers quickly.
 Comparing Treasure Bill
and Municipal Bond, which
one’s interest rate is
higher?
 Structure of Interest Rate
Tax Considerations
Municipal bond vs. Treasure Bill
Municipal bonds are certainly not default-free: State
and local governments have defaulted on the
municipal bonds they have issued in the past,
particularly during the Great Depression. Also,
municipal bonds are not as liquid as U.S. Treasury
bonds.
Why is it that these bonds have had lower interest
rates than U.S. Treasury bonds for at least 40 years?
• The explanation lies in the fact that interest
payments on municipal bonds are exempt
from federal income taxes, a factor that has
the same effect on the demand for municipal
bonds as an increase in their expected
return.
 Summary
• The risk structure of interest rates is explained
by three factors: default risk, liquidity, and the
income tax treatment of the bond’s interest
payments. As a bond’s default risk increases, the
risk premium on that bond rises. The greater
liquidity of Treasury bonds also explains why
their interest rates are lower than interest rates
on less liquid bonds. If a bond has a favorable
tax treatment, as do municipal bonds, whose
interest payments are exempt from federal
income taxes, its interest rate will be lower.
 Term Structure
• Another factor that influences the interest
rate on a bond is its term to maturity: Bonds
with identical risk, liquidity, and tax
characteristic may have different interest
rates because the time remaining to maturity
is different.
 Structure of Interest Rate
Term Structure
A good theory of the term structure of interest rates
must explain the following three important
empirical facts:
• Interest rates on bonds of different maturities move
together over time
• When short-term interest rates are low, yield curves
are more likely to have an upward slope; when
short-term interest rates are high, yield curves are
more likely to slope downward and be inverted
• Yield curves almost always slope upward
 Structure of Interest Rate

Three theories have been put forward to

explain the term structure of interest
rates:
• Pure expectations theory
• Market segmentation theory
• Liquidity premium theory
 Pure expectations theory
• The interest rate on a long term bond will
equal an average of short term interest rates
that people expect to occur over the life of
the long term bond.
• The key assumption behind this theory is
that buyers of bonds do not prefer bonds of
one maturity over another. (perfect
substitute)
 Pure expectations theory
• What this means in practice is that if bonds
with different maturities are perfect
substitutes, the expected return on these
bonds must be equal.
• A rise in short-term rates will raise people’s
expectations of future short-term rates.
• When short-term rates are low, people
generally expect them to rise to some normal
level in the future.
 Market segmentation theory

• This theory of the term structure sees

markets for different-maturity bonds as
completely separate and segmented. The
interest rate for each bond with a different
maturity is then determined by the supply
and demand of that bond.
• The key assumption in market segmentation
theory is that bonds of different maturities
are not substitute at all.
 Market segmentation theory

• Investors will be concerned with the

expected returns only for bonds of the
maturity they prefer. This might occur
because they have a particular holding
period in mind, and if they match the
maturity of the bond to the desired holding
period, they can obtain a certain return with
no risk at all.
 Market segmentation theory

• In this theory, differing yield curve patterns

are accounted for by supply and demand
differences associated with bonds of
different maturities. If , as seems sensible,
investors generally prefer bonds with
shorter maturities that have less interest-rate
risk, market segmentation theory can
explain fact 3.
 Liquidity premium theory

• This theory of term structure believes that

the interest rate on a long term bond will
equal an average of short term interest rates
expected to occur over the life of the long
term bond plus a liquidity premium that
responds to supply and demand conditions
for that bond.
• The key assumption is that bonds of
different maturities are substitutes.
 Some Concerns
• Weight of bad assets from state-owned banks
• Efficiency of state-owned business
• Related to the marketization of exchange rate
• Financial market still need to be further
standardized and consummated
• Financial derivative market also need to be
further developed