FUNDAMENTALS OF BUSINESS ECONOMICS

C.  Interest Rates and Why They Change

1.  Factors affecting the interest rate

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a.  Real risk-free interest rate

• Reflects time preference for money - tradeoff between current and future consumption

• Determined by market forces

• Rate at which government can borrow if government is stable

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b.  Risk premium

• Compensates investors for uncertainty

(1)  Country risk premium

• Based on economic, political, and social conditions

(a)  Market risk premium

• Due to volatility in cash flow caused by macroeconomic forces

- Exchange rates, interest rates, GDP growth, inflation, consumer preferences, expectations, credit availability, inputs prices, market structure, productivity

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(b)  Political/social risk premium

• Due to political and social conditions relative to the rest of the world

- Rule of law, stability and competence of government, fairness of political process, corruption, government intervention, social unrest and turmoil

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(2)  Industry risk

• Some industries riskier than others

• Usually slow to change

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(3)  Credit risk

(a)  Default risk

• Risk that borrowers will be unable to repay debt

• Depends on solvency - assets exceeding liabilities

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(b)  Liquidity risk

• Risk that borrowers will be unable to service their debts

• Depends on cash flow

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c.  Taxes and subsidies

• Taxes increase real interest rates, subsidies reduce real interest rates

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d.  Maturity

• Term structure of interest rates - relationship between an assets nominal yield and its maturity

• Yield curve - graphical representation

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2.  Real loanable funds market

a.  Supply of loanable funds

• Upward sloping

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(1)  Movements along supply curve

• More loanable funds supplied by households, businesses, government, foreign sector, and banks when real interest rate goes up

• Less loanable funds supplied by households, businesses, government, foreign sector, and banks when real interest rate goes down

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(2)  Shifts of supply curve

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(a)  Households

i)  Real GDP

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ii)  Real wealth

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iii)  Expectations

• Economic, political, social environment

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iv)  Indebtedness

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v)  Taxes

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(b)  Businesses

i)  Real GDP

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ii)  Taxes

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iii)  Expectations

• Economic, political, social environment

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(c)  Government

• Increase in government surpluses increases supply of loanable funds and vice versa

i)  Real GDP

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ii)  Discretionary government spending

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iii)  Discretionary taxes

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(d)  Foreigners

• Depends on net exports

i)  Real GDP

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ii)  Country risks

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(e)  Money supply

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b.  Demand for loanable funds

• Downward sloping

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(1)  Movements along demand curve

• Real interest rate up => less borrowing => fewer funds demanded by households, businesses, government, and foreign sector

• Real interest rate down => more borrowing => more funds demanded by households, businesses, government, foreign sector

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(2)  Shifts of demand curve

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(a)  Households

i)  Expectations

• Prices, interest rates, incomes

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ii)  Taxes and subsidies

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iii)  Consumer indebtedness

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(b)  Businesses

i)  Expectations

• Prices, revenue, profits, interest rates

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ii)  Taxes and subsidies

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iii)  Indebtedness

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iv)  Regulations

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v)  Real GDP

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(c)  Government

• Increase in government deficit increases demand for loanable funds and vice versa

i)  Real GDP

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ii)  Discretionary taxes

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iii)  Discretionary spending

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(d)  Foreign sector

i)  Country risks

• Indirect impact

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ii)  Expectations

• Prices, sales revenue, profits, interest rates

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iii)  Taxes and subsidies

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c.  Equilibrium

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d.  Impact of changes

Ex. - Rising government deficits

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Ex. - Expansionary monetary policy

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Ex. - Business cycles

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