Interest and Real Rate

P6–1 Interest rate fundamentals: The real rate of return Carl Foster, a trainee at an Investment banking firm, is trying to get an idea of what real rate of return investors Are expecting in today’s marketplace. He has looked up the rate paid on 3-month U.S. Treasury bills and found it to be 5.5%. He has decided to use the rate of change In the Consumer Price Index as a proxy for the inflationary expectations of Investors. That annualized rate now stands at 3%. On the basis of the information That Carl has collected, what estimate can he make of the real rate of return?

P6–2 Real rate of interest To estimate the real rate of interest, the economics division of Mountain Banks—a major bank holding company—has gathered the data summarized In the following table. Because there is a high likelihood that new tax legislation Will be passed in the near future, current data as well as data reflecting the Probable impacts of passage of the legislation on the demand for funds are also

With passage Currently of tax legislation
Amount of funds Interest rate Interest rate Interest rate supplied/demanded required by required by required by
($ billion) funds suppliers funds demanders funds demanders

$ 1 2% 7% 9%
5 3 6 8
10 4 4 7
20 6 3 6
50 7 2 4
100 9 1 3

included in the table. (Note: The proposed legislation will not affect the supply schedule of funds. Assume a perfect world in which inflation is expected to be zero, funds suppliers and demanders have no liquidity preference, and all outcomes are certain.)

a. Draw the supply curve and the demand curve for funds using the current data.
(Note: Unlike the functions in Figure 6.1 on page 223, the functions here will not appear as straight lines.)

b. Using your graph, label and note the real rate of interest using the current data.

c. Add to the