Morton Handley Ad Company: Interest Rate Determination
Integrated Case
6-21
Morton Handley & Company
Interest Rate Determination
Maria Juarez is a professional tennis player, and your firm manages her money. She has asked you to give her information about what determines the level of various interest rates. Your boss has prepared some questions for you to consider. A. What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy? Answer: [Show S6-1 and S6-2 here.] The four most fundamental factors affecting the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation. Production opportunities are the investment opportunities in productive (cash-generating) assets. Time preferences for consumption are the preferences of consumers for current consumption as opposed to saving for future consumption. Risk, in a financial market context, is the chance that an investment will provide a low or negative return. Inflation is the amount by which prices increase over time. The interest rate paid to savers depends (1) on the rate of return producers expect to earn on invested capital, (2) on savers’ time preferences for current versus future consumption, (3) on the riskiness of the loan, and (4) on the expected future rate of inflation. Producers’ expected returns on their business investments set an upper limit to how much they can pay for
Chapter 6: Interest Rates
Integrated Case
1
savings, while consumers’ time preferences for consumption establish how much consumption they are willing to defer, hence how much they will save at different interest rates. Higher risk and higher inflation also lead to higher interest rates. B. What is the real risk-free rate of interest (r*) and the nominal riskfree rate (rRF)? How are these two rates measured? Answer: [Show S6-3 and S6-4 here.] Keep these equations in mind as we discuss interest rates. We will define the terms as we go along: r = r* + IP
6-21
Morton Handley & Company
Interest Rate Determination
Maria Juarez is a professional tennis player, and your firm manages her money. She has asked you to give her information about what determines the level of various interest rates. Your boss has prepared some questions for you to consider. A. What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy? Answer: [Show S6-1 and S6-2 here.] The four most fundamental factors affecting the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation. Production opportunities are the investment opportunities in productive (cash-generating) assets. Time preferences for consumption are the preferences of consumers for current consumption as opposed to saving for future consumption. Risk, in a financial market context, is the chance that an investment will provide a low or negative return. Inflation is the amount by which prices increase over time. The interest rate paid to savers depends (1) on the rate of return producers expect to earn on invested capital, (2) on savers’ time preferences for current versus future consumption, (3) on the riskiness of the loan, and (4) on the expected future rate of inflation. Producers’ expected returns on their business investments set an upper limit to how much they can pay for
Chapter 6: Interest Rates
Integrated Case
1
savings, while consumers’ time preferences for consumption establish how much consumption they are willing to defer, hence how much they will save at different interest rates. Higher risk and higher inflation also lead to higher interest rates. B. What is the real risk-free rate of interest (r*) and the nominal riskfree rate (rRF)? How are these two rates measured? Answer: [Show S6-3 and S6-4 here.] Keep these equations in mind as we discuss interest rates. We will define the terms as we go along: r = r* + IP