Ch5 determination of interest rate

nullCh5. Determination of interest rateCh5. Determination of interest rateTo understand The role of interest rate in economy (preliminary) The theories of determination of interest rate Classical theory Loanable funds theory Liquidity preference theory Rational expectation theory The elements to influence interest rate5.1 the role of interest rate in economy5.1 the role of interest rate in economyInterest rate is the key issues to determine the volume & transformation of saving to investment Allocated the saving resources & credit resources The key element to influence the equilibrium of money supply and money demand An important benchmark for value of other financial instruments (bonds, shares, funds) An important macro-economic policy5.2 Conceptions of interest rate5.2 Conceptions of interest rateThe rate of interest is a payment from borrow to lenders which compensates the latter for parting with funds for a period of time and at some risk. It is rewarding savers for giving-up the ability to consume for a period of time. Nominal interest rates are the rates of interest that are actually paid in money form. The real interest is the return that lenders require even if there is no risk and prices are constant. This is the pure return for giving up the ability to spend for a period of time. Since the time have value, the long-term real interest rate will be higher than short-term real interest rate.5.3 classical theory of interest rates5.3 classical theory of interest ratesClassical theory of interest rates is an explanation of the level of and changes in interest rates that relies on the interaction of the supply of savings and the demand for investment capital. It also called as real flow of funds theory.nullnullthe equilibrium rate of interest in classical theory of interest5.4 Loanable funds theory of interest 5.4 Loanable funds theory of interest Loanable funds theory of interest was Primarily developed by monetary economist Dennid Robertson (1933). Keynesian theory. it think that the demand and supply of “loanable funds” decide real interest rate.null5.4.1 The demand of Loanable funds5.4 Loanable funds theory of interest 5.4 Loanable funds theory of interest 5.4.2 supply of LFs5.4.3 case study about equilibrium rate5.4.3 case study about equilibrium rateThe factors of supply： The saving of household: +,- the critiral of loan of bank:+ - Money supply of central bank + -5.4 Loanable funds theory of interest The elements that influence the demand of loanable curve Confidence of consumers Reduce of fiscal deficits Slump of stock market, damage the confidence of firmsChang of the demand of LFsChang of LFs supply5.5 liquidity preference theory of interest rates5.5 liquidity preference theory of interest rates5.5.1 demand of liquidity Motives：Transaction precautionary and speculation demand Demand of money：M/p=f(Y, i)5.5.2 equilibrium of interest rate of liquidity theory： money supply＝money demandLiquidity preference theory of interest rate : an explanation of the level of and change in interest rates that focuses on the interaction of the supply of and demand for money null5.5 liquidity preference theory of interest rates5.5 liquidity preference theory of interest ratesLP theory provides some useful insights into investor behavior and the influence of government policy on the economy and financial system. It illustrates how central banks can influence interest rates in the financial markets in short term.MS & interest rate: a combined effect in a periodnullSummary of the liquidity preference approach: Agent’s actions determine nominal interest rates. Real rate will depend upon the behavior of prices and the extent to which price changes are correctly anticipated; The nominal rate is determined by the demand for money relative to its supply; The demand for money depends upon the price level and upon the level of economic activity but it also depends upon the desire to hold money as a safe asset in as uncertain world; The degree of uncertainty that agents feel is highly variable, leading to fluctuations in the demand for money and hence in the nominal rate of interest; The supply of money is independent of the demand for it and is assumed to be fixed by the actions of the monetary authorities.5.5 liquidity preference theory of interest rates5.5 liquidity preference theory of interest rates5.5.3 limitations of the liquidity preference theory Only concern the demand & supply of the money. Neglected the actions of other sectors or neglected the demand & supply of funds of others sectors. It is a short-term approach to interest rate determination (because it assumes that income remains stale). In the longer term, interest rates are affected by changes of levels of income and by inflationary expectations.5.6 the rational expectations theory5.6 the rational expectations theoryRational expectations theory of interest rates : an explanation of the level of and changes in interest rates based on changes in investor expectations regarding future security prices and returns. This theory builds on research evidence that the money and capital markets are highly efficient institutions in digesting new information affecting interest rates and security prices. New information: the key playerExpectation and Action : buy or sellEquilibrium 5.6 the rational expectations theory理性预期理论5.6 the rational expectations theory理性预期理论5.6.1 the assumption of rational expectations theory market is perfectly efficient The interest rate and price of securities have reflected all the useful and avaliable informant individuals are rational agents who form expectations about the distribution of future prices of security and interest rates. Rational agents attempt to make optimal use of the resources. They make unbiased forecasts of future prices, interest rates. No systematic forecasting errorsThe change of interest rate and price of securities are only related to the unexpected information. The transaction cost and storage cost of securities can be neglected 5.6.2 the equilibrium of interest rate If all above assumptions can be hold, the equilibrium of interest rate should be exactly the rate of expectation rate, namely: E（r）= r No systematic forecasting errors The passed information has no influence on change of interest rate The change of interest rate is decided by the change of expectation. 5.7 evaluation of rational expectation theory5.7 evaluation of rational expectation theoryThe theory explains some phenomenon about changing of interest rate and prices of the securities that can not be explained by the traditional theories. Some of the assumptions can be hold or accepted Some of testing evidences about the role of expectation Mishkin，Pipperger：the current changing of interest rates do not have clearly relations with the current returns of bonds & other shares. The expectation have already influenced the prices of those securities. Engle & Frankel,(1984) the passed information has almost not influence on the level of interest rate. The unexpected information has clearly correlation with rate of return of bonds & securities， expecially has storng correlation with short-term interest rate. Some criticism: The model about formation of expectation of public can not be conviction. Assumption about the zero transaction cost is no realistic. The information for decision making is so simple that it can not provide foundation to assure that the decision is rationality.5.7 Loanable fund theory + rational expectation: －a better modification? 5.7 Loanable fund theory + rational expectation: －a better modification? The challenge for the monetary policy If the policymaker can not know the expectation of public about the rate, the policy they made may cause the opposite results Before implementation of the policy, the authorities should anticipate what kinds of new information will be emerging. Maybe the new information which to be relied on deciding the new policy should not be expected by the market. E0E1E2rMSDIf Modified the LF theory with the rational expectation theory, the rational expectation theory can has its fundamental of analyses, and the LF theory can combine the expectation elements. The demand & supply of loanable funds not only reflects the real demand & supply but also reflect the expected demand & supply. The interest rate is determined by the real demand & supply as well as the expectation about them. Namely:Modified the limitations of LF & RE theories: 5.8 factors that influence the interest rate5.8 factors that influence the interest rate many of the factors can influence the demand & supply of loanable funds as well as the expectation about them, and therefore the nominal interest rate: the most important factors including: Expectation about inflation Fiscal deficits The monetary policy of the central bank Economic cycle 5.8 factors that influence the interest rate5.8 factors that influence the interest rate7.8.1 inflation and interest rate7.8.2 expected inflation & Fisher effects（1896） Fisher’s effect: The changing of expected inflation will cause the change of nominal interest rate Function of Fisher’s effect: i = r + ßpe where： i: nominal rate；r: real rate (when inflation rate is 0)；pe : expected inflation rate；ß: adjusted coefficientThe radical view about Fisher’s effect think that ß=1. Harrod—Kenyes effect：the inflation does not influence the nominal rate but the real rate. The Classical & the Loanable funds theories think that there is Fisher’s effect between inflation & interest rate. ß=1 or is approximate to 1. null5.8.3 interest rate & monetary policy5.8.3 interest rate & monetary policyThe monetary policy may influence: Short term interest rate directly (liquidity effect) The supply curve of loanable funds The expectation about inflation Long-term interest rate through income effect, price effects, and expectation of inflation. Unexpected policy influence the real interestCase 1. unexpected MS:Case 2. Taylor’s Rule & short term ratenullT—bonds rates and business cycle. US. 1964—2000. figures How about China?5.8.4 business cycle & interest ratesObserve: Interest rates rise during business cycle expansions and fall during recessions