Lecture 7

Finance and the Loanable Funds Market

Interest rate: rental price of money

positive rate of time preference: people prefer to have something now rather than later. So to give up the use of money today, people must be compensated, or equivalently, to have access to goods today without the money to pay for it, one needs to pay the price to borrow money.

nominal interest rate: the market rate at which money is loaned.

real interest rate = nominal interest rate - inflation rate

example: 1 year loan of %1,000 @ 10% nominal interest rate

at the end of the year you get $1,100

if inflation is zero, you can buy the same amount of goods and services with $100 before the loan as after.

if inflation is equal to 5%, you get $100 at end of the year but it buys fewer goods and services so the real return is 5%.

Why many rates?

1) different rates reflect different default risks associated with the loans

2) duration of loans (long-term versus short-term) economic conditions can change overt he course of the loan or inflation could change which means that there is more uncertainty in the long term.

generally think that the government is most secure borrower thus they give a lower rate.

long-term rates generally greater than short-term but not always.

How are interest rates determined?

for now weíll ignore inflation and look at the real interest rate

Loanable Funds Market

Suppliers of loanable funds

a)households: 1987: personal savings $180 billion (but the US savings rate is low)

1994: personal savings $203 billion (4.2% of disposable personal income)

b) business: 1987 business savings $550 billion (US business savings rate is high)

1996 business savings $886 billion

c) government

i) state and local 1987 state and local saving

ii) federal 1987 federal savings

d) 1987 foreign savings 156 billion (minimal factor until 1983)

1995 foreign savings 136 billion

as the real interest rate rises savers save more since the return to savings has risen as well.

Demanders of Loanable Funds

(a) Consumer Credit

i) owner-occupied homes: largest component

ii) cars, etc.

(b) Corporate Borrowing

i) borrow from bank: usually short term based on

financed by several banks ii) issue bonds

in the primary market firms sell bonds to public

example: company borrows $100 today and promises

1) to pay $100 3 years from now: this is called par valued or face value.

2) to pay $10 each year: coupon

in the primary market, the bond yield approximates the market rate.

secondary market-bond holders trading bonds

bond price varies with interest rate.

NET PRESENT VALUE: value now of getting money in the future

Rt = payment received in year t

r = interest rate in the market (not the yield on the bond)

n = total number of years

example: 3 year bond

par value = 100

coupon = 10

yield = 10%

if the market interest rate is 10%

if the yield equals the market interest rate, then the NPV or price of a bond is equal to the par value.

example: 3 year bond

par value = 100

coupon = 10

yield = 10%

if after the bond is issued, the market rate of interest rises to 15% what happens to the price of the bond? (remember that the coupon and the yield are fixed for the life of the bond)

The bond price is lower, it is now worth less because its yield is lower than in the market (people wonít pay as much for the bond after the change in the interest rate as they would have been willing before the change in the interest rate.)

As the market interest rate falls, the price of the bond rises.

As the market interest rate rises, the price of the bond falls.

iii) issue stocks:

primary market: firms sell new equities raise money for firms

secondary market: stock holders trade stocks no new money for firms.

stocks are part of firmís ownership

stocks pay dividends (though not fixed like coupons)

stocks may rise in price which yields capital gains. As profit and dividend expectations change stocks tend tomove the same direction as bonds.

Dividend yield

e.g. ($4.40/$112.875)100%=3.9% on IBM stock

(c) Government Borrowing:

i) issue bonds: works like corporate bonds

(d) Foreign Borrowing

as r rises, more expensive to borrow and fewer loans demanded.

Equilibrium in the Loanable Funds

GNP = C + I + G + (X - M)

and

Total Income = C + S + T

and

GNP = Total Income

C + S + T = C + I + G + (X - M)

rearranging:

I = S + (T - G) + (M - X)

investment = (private saving) + (government saving) + ( foreign saving)

or