The higher the expected rate of inflation, the larger the required dollar return. We discuss this point in detail later in the chapter. Thus, we see that the interest rate paid to savers depends (1) on the rate of return that producers expect to earn on invested capital, (2) on savers’ time preferences for current Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chapter 6 Interest Rates 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 savings, while consumers’ time preferences for consumption establish how much consumption they are willing to defer and hence how much they will save at different interest rates.1 Higher risk and higher inflation also lead to higher interest rates. SelfTest What is the price paid to borrow debt capital called? What are the two items whose sum is the cost of equity? What four fundamental factors affect the cost of money? Which factor sets an upper limit on how much can be paid for savings? Which factor determines how much will be saved at different interest rates? How do risk and inflation impact interest rates in the economy? 6-2 Interest Rate Levels Borrowers bid for the available supply of debt capital using interest rates: The firms with the most profitable investment opportunities are willing and able to pay the most for capital, so they tend to attract it away from inefficient firms and firms whose products are not in demand. At the same time, government policy can also influence the allocation of capital and the level of interest rates. For example, the federal government has agencies that help designated individuals or groups obtain credit on favorable terms. Among those eligible for this kind of assistance are small businesses, certain minorities, and firms willing to build plants in areas with high unemployment. Still, most capital in the United States is allocated through the price system, where the interest rate is the price. Figure 6.1 shows how supply and demand interact to determine interest rates in two capital markets. Markets L and H represent two of the many capital markets in existence. The supply curve in each market is upward sloping, which indicates that investors are willing to supply more capital the higher the interest rate they receive on their capital. Likewise, the downward-sloping demand curve indicates that borrowers will borrow more if interest rates are lower. The interest rate in each market is the point where the supply and demand curves intersect. The going interest rate, designated as r, is initially 5% for the low-risk securities in Market L. Borrowers whose credit is strong enough to participate in this market can obtain funds at a cost of 5%, and investors who want to put their money to work without much risk can obtain a 5% return. Riskier borrowers must obtain higher cost funds in Market H, where investors who are more willing to take risks expect to earn a 7% return but also realize that they might receive much less. In this scenario, investors are willing to accept the higher risk in Market H in exchange for a risk premium of 7% 2 5% 5 2%. Now let’s assume that because of changing market forces, investors perceive that Market H has become relatively more risky. This changing perception The term producers in this example is too narrow. A better word might be borrowers, which would include corporations, home purchasers, people borrowing to go to college, and even people borrowing to buy autos or to pay for vacations. Also, the wealth of a society and its demographics influence its people’s ability to save and thus their time preferences for current versus future consumption. 1 Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
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