Deck 5: The Determinants of Interest Rates: Competing Ideas

Question 1

Most government saving is unintended.

Answer 1

True

Question 2

The wealth effect was very strong during the stock market and housing booms of the late 1990s when the personal savings rate went negative as households consumed more than their income.

Answer 2

True

Question 3

Explain the meaning of the term pure or risk-free rate of interest? Why is this interest rate important and what is its relationship to other interest rates in the money and capital markets?

Answer 3

Pure or risk-free rate of interest is one fundamental interest rate by our assumption. The pure or risk-free rate of interest is a component of all interest rates. While the pure or risk-free rate of interest exists only in theory, the closest real-world approximation to this pure rate of return is the market interest rate on government bonds. It is a rate of return presenting little or no risk of financial loss to the investor and representing the opportunity cost of holding idle cash because the investor can always invest in government bonds of the lowest risk and earn this minimum rate of return.

Question 4

If we could identify the forces shaping the level of and changes in the risk-free or pure rate of interest, what advantage could this give to us in trying to explain the many different interest rates we see everyday in the real world?

Question 5

In the so-called Classical theory of interest rates what major forces determine the market rate of interest?
What assumptions does the Classical theory of interest rest upon?

Question 6

Explain why the supply curve in the Classical theory of interest rates has a positive slope? Why does the demand curve in the Classical theory have a negative slope?

Question 7

What are the origins of the Liquidity Preference Theory of Interest? What main assumptions seem to underlie this important idea about what determines the level of and changes in market rates of interest?

Question 8

What factors appear to determine the transactions demand for money? How about the precautionary motive for demanding and holding money? The speculative motive?

Question 9

What makes up the total demand for money? What is the shape of the relationship between the total demand for money and the market rate of interest?

Question 10

What are the principal limitations of the Liquidity Preference Theory of Interest?

Question 11

What are loanable funds? Why is this term important?

Question 12

What factors make up the total demand for loanable funds? The total supply of loanable funds? Please list and define each of these demand and supply factors in the Loanable Funds Theory of Interest?

Question 13

Suppose the demand for loanable funds increases relative to the supply. What happens to the equilibrium rate of interest? Suppose, on the other hand, the supply of loanable funds expands with loanable funds demand unchanged? What does the equilibrium loanable funds interest rate look like under these circumstances? Can you draw a picture of these changes in the equilibrium interest rate?

Question 14

What does it take to have a permanently stable equilibrium interest rate under the Loanable Funds Theory of Interest? How does this differ from a temporary or partial equilibrium loanable funds rate?

Question 15

Can you explain what is meant by "rational expectations"?

Question 16

What key assumptions underlie the rational expectations view of interest?

Question 17

What are the implications of the rational expectations theory of interest for those who try to forecast changes in market rates of interest? Based on this view of interest rates what would you recommend to interest-rate forecasters?

Question 18

Suppose the going market rate of interest on high-quality corporate bonds is 12 percent. FORTRAN Corporation is considering an investment project which will last 10 years and requires an initial cash outlay of $1.5 million. It will generate estimated revenues of $500,000 per year for 10 years. Would you recommend that this project be adopted? Explain why.

Question 19

Several statements are presented as they appeared in recent news stories. The reader is asked to indicate:
(a) which theory of interest rate determination is implicit in each statement; and (b) which direction interest rates should move if the published statement is correct.

Question 20

Suppose that total savings and business investment demand in the economy behaves as given. According to the Classical theory of interest what equilibrium interest rate will prevail given the above schedules of planned saving and investment? What could cause the equilibrium rate to change?

Question 21

INLAC Company, Ltd. is examining two investment projects as a part of its expansion plan for the coming year. These two projects are not mutually exclusive. The cost of Project A is $9,870 while the second project (B) is expected to cost $17,850. INLAC's cost of capital (required rate of return) is 12 %. Expected annual cash flows are projected to be as follows:
$\begin{array}{llr} \text {Year } & \text {Project A } &\text { Project B }\\1 &\$3,310 &\$6,525\\2 &\$3,310 &\$6,525\\3&\$3,310&\$6,525\\4&\$3,310 &\$6,525\\5 &\$3,310 &\$6,525\\\end{array}$

Each project will last an estimated 5 years with no remaining significant scrap value. Determine the IRR and the NPV for each of these two projects. What should INLAC decide about each proposed project, assuming the above figures are truly accurate?