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. 197 198 Part 3 Financial Assets Interest Rates as a Function of Supply and Demand for Funds F I G U R E 6 .1 Market L: Low-Risk Securities Market H: High-Risk Securities Interest Rate, r (%) Interest Rate, r (%) S2 S1 S 2 S1 8 rH = 7 rL = 5 4 D D 0 Dollars 0 Dollars will induce many investors to shift toward safer investments—referred to as a “flight to quality.” As investors move their money from Market H to Market L, the supply of funds is increased in Market L from S1 to S2, and the increased availability of capital will push down interest rates in this market from 5% to 4%. At the same time, as investors move their money out of Market H, there will be a decreased supply of funds in that market, and tighter credit in that market will force interest rates up from 7% to 8%. In this new environment, money is transferred from Market H to Market L and the risk premium rises from 2% to 8% 2 4% 5 4%. There are many capital markets in the United States, and Figure 6.1 highlights the fact that they are interconnected. U.S. firms also invest and raise capital throughout the world, and foreigners both borrow and lend in the United States. There are markets for home loans; farm loans; business loans; federal, state, and local government loans; and consumer loans. Within each category, there are regional markets as well as different types of submarkets. For example, in real estate, there are separate markets for first and second mortgages and for loans on single-family homes, apartments, office buildings, shopping centers, and vacant land. And, of course, there are separate markets for prime and subprime mortgage loans. Within the business sector, there are dozens of types of debt securities and there are several different markets for common stocks. There is a price for each type of capital, and these prices change over time as supply and demand conditions change. Figure 6.2 shows how long- and shortterm interest rates to business borrowers have varied since the early 1970s. Notice that short-term interest rates are especially volatile, rising rapidly during booms and falling equally rapidly during recessions. (The shaded areas of the chart indicate recessions.) In particular, note the dramatic drop in short-term interest rates during the most recent recession. When the economy is expanding, firms need capital, and this demand pushes rates up. Inflationary pressures are strongest during business booms, also exerting upward pressure on rates. Conditions are reversed during recessions: Slack business reduces the demand for credit, inflation falls, and the Federal Reserve increases the supply of funds to help stimulate the economy. The result is a decline in interest rates. These tendencies do not hold exactly, as demonstrated by the period after 1984. Oil prices fell dramatically in 1985 and 1986, reducing inflationary pressures on other prices and easing fears of serious long-term inflation. Earlier these fears had pushed interest rates to record levels. The economy from 1984 to 1987 was strong, but the declining fears of inflation more than offset the 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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