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Ebook Financial markets and institutions (5E): Part 2

(BQ) Part 2 book "Financial markets and institutions" has contents: Foreign exchange markets; exchange rate risk, derivatives markets and speculation, international capital markets, government borrowing and financial markets, the regulation of financial markets. | FINM_C07.qxd 1/18/07 11:33 AM Page 201 www.downloadslide.com CHAPTER 7 Interest rates Objectives What you will learn in this chapter: l The relationship between nominal and real rates of interest l The loanable funds theory of real interest rates and its adaptation to deal with nominal interest rates l The liquidity preference theory of interest rates and how it relates to the loanable funds approach l How the monetary authorities strongly influence the general level of interest rates in the economy l The meaning of the term structure of interest rates and the various theories used to explain the term structure We have seen many times that an interest rate is one form of yield on financial instruments – that is, it is a rate of return paid by a borrower of funds to a lender of them. We can also think of an interest rate as a price paid by a borrower for a service, the right to make use of funds for a specified period. We shall here be looking at two questions: (a) What determines the average rate of interest in an economy? and (b) Why do interest rates differ on loans of different types and different lengths – that is, what factors influence the structure of interest rates in an economy? Of course, interest rates also vary depending on whether you are borrowing or lending. For example, there is a spread between the interest rate at which banks are prepared to lend (the offer rate) and the rate they are willing to pay to attract deposits (the bid rate). There is also a spread between selling and buying rates in international money markets. For example, the Financial Times of 25 May 2006 quoted the interest rate on short-term sterling in international currency markets as 45/8 per cent (the offer rate) to 41/2 per cent (the bid rate). If we wish to quote a single interest rate in such a case, we can specify that we are referring to the offer rate or the bid rate – as in the distinction between LIBOR (the London Interbank Offered Rate) and .