In this chapter we will: Learn to measure risk and assess whether it will increase or decrease, understand why changes in risk lead to changes in the demand for a particular financial instrument, understand why change in risk lead to corresponding changes in the price of those instruments. | Chapter 5 The Determinants of Interest Rates: Competing Ideas 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 interest rates and asset prices into motion. Introduction The acts of saving and lending, and borrowing and investing, are significantly influenced by and tied together by the interest rate. The interest rate is the price a borrower must pay to secure scarce loanable funds from a lender for an agreed-upon time period. 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. Whether higher interest rates increase or decrease savings and investment depends on the relative strength of its effect on supply and demand factors. . | Chapter 5 The Determinants of Interest Rates: Competing Ideas 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 interest rates and asset prices into motion. Introduction The acts of saving and lending, and borrowing and investing, are significantly influenced by and tied together by the interest rate. The interest rate is the price a borrower must pay to secure scarce loanable funds from a lender for an agreed-upon time period. 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. Whether higher interest rates increase or decrease savings and investment depends on the relative strength of its effect on supply and demand factors. 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 demand for money. Functions of the Interest Rate in the Economy The interest rate serves as an important tool for government policy through its influence on the volume of savings and investment. Functions of the Interest Rate in the Economy To help uncover these rate-determining forces, we assume that there is one fundamental interest rate, known as the pure or risk-free rate of interest, which is a component of all interest rates. The closest real-world approximation to this pure rate of return is the market interest rate on government bonds. The Classical Theory of Interest Rates The classical theory argues that the rate of interest is
