Financial Markers and Institutions

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CHAPTER TWO
INTEREST RATES

Chapter Objectives

After studding this chapter, you will be able to:
Define what interest rate is
Realize the functions of interest rate in the economy
Know the distinction between interest rate and returns
Explain the different theories of the rate of interest as well as the limitations of each theories 2.1 INTRODUCTION

The money and capital markets are one of the vast pools of funds, depleted by the borrowing activities of households, businesses and governments and replenished by the savings these sectors supply to the financial system. The money and capital markets make saving possible by offering the individual saver a wide menu of choices where funds may be placed at attractive rates of return. By committing funds to one or more financial instruments, the saver, in effect, becomes a lender of funds. The financial markets also make borrowing possible by giving the borrower a channel through which securities (I Owe You) (IOUs) can be issued to lenders. And the money and capital markets make investment and economic growth possible by providing the funds needed for the purchase of machinery and equipment and the construction of buildings, highways, and other productive facilities.

Clearly, then, the acts of saving and lending, borrowing and investing are intimately linked through the financial system. And one factor that significantly influences and ties all of them together is the rate of interest. The rate of interest is the price a borrower must pay to secure scarce loanable funds from a lender for an agreed-upon period. It is the price of credit. But unlike other prices in the economy, the rate of interest is really a ratio of two quantities: the money cost of borrowing divided by the amount of money actually borrowed, usually expressed as an annual percentage basis.

Interest rates send price signals to borrowers, lenders, savers, and investors. For example, higher interest rates generally bring forth a greater volume of savings and stimulate the lending of funds. Lower rates of interest, on the other hand, tend to dampen the flow of savings and reduce lending activity. Higher interest rates tend to reduce the volume of borrowing and capital investment, and lower rates stimulate borrowing and investment spending. In this chapter, we will discuss in more detail the forces that are believed by economists and financial analysts to determine prevailing rates of interest in the financial system.

2.2 FUNCTIONS OF THE RATE OF INTEREST IN THE ECONOMY

The rate of interest performs several important roles or functions in the economy: It helps guarantee that current savings will flow into investment to promote economic growth. It rations the available supply of credit, generally providing loanable funds to those investment projects with the highest expected returns. It brings into balance the supply of money with the public’s demand for money. It is also an important tool of government policy through its influence on the volume of saving and investment. If the economy is growing too slowly and unemployment is rising, the government can use its policy tools to lower interest rates in order to stimulate borrowing and investment. On the other hand, an economy experiencing rapid inflation has traditionally called for a government policy of higher interest rates to slow both borrowing and spending.

To uncover these basic rate-determining forces, however, we must make a simplifying assumption. We assume in this chapter that there is one fundamental interest rate in the economy known as the pure or risk-free rate of interest, which is a component of all interest rates. The closest approximation to this pure rate in the real world is the market yield on government bonds. It is a rate of return presenting little or no risk of financial loss to the investor and representing the opportunity cost of holding idle cash, because the investor can always invest in...
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