there is one fundamental interest rate, known as the pure or . riskfree rate of interest , which is a component of all interest rates[r]
(1)(2)Chapter 5
The Determinants of
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Money and Capital Markets, 9/e © 2006 The McGrawHill Companies, Inc., All Rights Reserved.
Learning Objectives
• To understand the important roles that interest rates play
within the economy
• To explore the most important ideas about what determines the level of interest rates and asset prices within the financial system
• To identify the key forces that economists believe set market
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Introduction
ã Theactsofsavingandlending,andborrowingandinvesting,
aresignificantlyinfluencedbyandtiedtogetherbytheinterest rate
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Introduction
• Some authorities refer to the rate of interest as the price of credit
• Interest rates send price signals to borrowers, lender, savers, and investors.
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Functions of the Interest Rate in the Economy
• The interest rate helps guarantee that current savings will flow
into investment to promote economic growth
• It allocates the available supply of credit, generally providing loanable funds to those investment projects with the highest expected returns
• It brings the supply of money into balance with the public’s
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FunctionsoftheInterestRateintheEconomy
ã Theinterestrateservesasanimportanttoolforgovernment
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FunctionsoftheInterestRateintheEconomy
ã To help uncover these ratedetermining forces, we assume that
there is one fundamental interest rate, known as the pure or
riskfree rate of interest, which is a component of all interest rates
• The closest realworld approximation to this pure rate of
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Money and Capital Markets, 9/e © 2006 The McGrawHill Companies, Inc., All Rights Reserved.
The Classical Theory of Interest Rates
• The classical theory argues that the rate of interest is
determined by two forces:
the supply of savings, derived mainly from households, and the demand for investment capital, coming mainly from the
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The Classical Theory of Interest Rates
Household Savings
• Current household savings equal the difference between current income and current consumption expenditures
• Individuals prefer current over future consumption, and the
payment of interest is a reward for waiting
• Higher interest rates encourage the substitution of current