Interest Rate

Published on June 2016 | Categories: Documents | Downloads: 46 | Comments: 0 | Views: 612
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INTEREST RATE

ROLE OF INTERSET RATE
• Interest rates are most commonly watched variables in the economy. • Their movements are recorded daily by the news media because they directly affect our lives everyday • It has important consequences for the health of the economy

• Interest rate affect personal decisions • It also affects economic decisions of business

Determinants of asset Demand
• An asset is a piece of property that is a store of value. • E.g. money , bonds, art , land, house, machine etc, • Facing the questions of whether to buy or hold an asset, or whether to buy one asset rather than another, an individual must consider some factors.

Factors to be considered
• Wealth • Expected Return

• Risk • Liquidity

• wealth : Holding everything else constant, an increase in wealth raises the quantity demanded for an asset. Expected return: An increase in an assets expected return relative to that of an alternative asset, holding everything else unchanged, raises the quantity demanded of the asset

• Risk: Holding everything else constant, if an assets risk rises relative to that of alternative assets, is quantity demanded will fall. Liquidity: the more liquid an asset is relative to alternative assets, holding everything else unchanged, the more desirable it is, and greater will be the quantity demanded.

REAL INTEREST RATE AND NOMINAL INTEREST RATE

• NOMINAL INTEREST RATE : This is the interest rate that ignores the cost of inflation and is more precisely referred as Nominal Interest rate.

• REAL INTEREST RATE • The interest rate that is adjusted by subtracting changes in the price level (inflation) so that it more accurately reflects the true cost of borrowing.

Theories of Interest Rate
• Fishers classical Approach: • The Market has Individuals who can either consume or Save their current income • The market has firms that wants to borrow loans and invest. • Default risk does not exist

• Decision On Saving: 1. Choice 2. Marginal rate of time preferences 3. Income 4. Reward for saving

• This description of saving income applies to all the people in the economy • The total savings (or the total supply of loans ) available at any time is the sum of everybody’s saving and a positive function of the interest rate.

• Borrowing decisions • No reward • Investment means directing resources to assets that will increase the firms future capacity to produce. • Gain from investments • The gain is not constant, at one point of time.

• The reason is that, at any given point only a certain no of projects are available. • Some of them offer high gains, moderate gains and others yielding low gains. • Firms will direct borrowed resources to projects in order of profitability , starting with most profitable and proceeding towards to those with lower gains.

The gain from extra projects, as investments increases, is the marginal Productivity of capital, which is negatively related to the amount of investment. In other words, as the amount of investments grows additional gains necessarily falls as more of the less profitable projects are accepted.

• The maximum that a firm will invest depends on the rate of interest which is the cost of loans. • The firm will invest only as long as the marginal productivity of capital exceeds or equals the rate of interest. • Thus the firms demand for borrowings is negatively related to the interest rate.

• If the rate is high only limited borrowings and investments makes sense • If the rate of interest is low, more projects offer a profit, and the firm wants to borrow more. • This negative relationship exist for each and all firms in the economy . • The economy's total demand for borrowed resources and loans (unconsumed income) as a function of the interest appears as the downward slopping line

• Equilibrium in the market • Effect of a sudden increase in technological capablity

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