Financial Markers and Institutions
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
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