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Sem 5 Prep
← Money & BankingWhat determines interest rates

Formulas for this chapter

Real interest rate, linear form

ir = i - pi(e)

Quick conversions, and whenever the Drive slides or the exercise on slide 13 are the reference. Good enough when both rates are small.

ir
Real interest rate, in per cent
i
Nominal interest rate, the rate actually quoted
pi(e)
Expected inflation rate over the same period

Fisher effect, exact form

(1 + N) = (1 + R)(1 + I) N = (1 + R)(1 + I) - 1 R = (1 + N) / (1 + I) - 1

The professor's own statement, and the one to use when either rate is large. The gap against the linear form is always the cross term R x I.

N
Nominal interest rate, as a decimal
R
Real interest rate, as a decimal
I
Inflation rate, as a decimal

Error in the linear approximation

Error (percentage points) = R x I x 100

To decide in one second whether the shortcut is safe. At 3% and 5% the error is 0.15 points; at 10% and 20% it is 2 points.

R
Real rate as a decimal
I
Inflation rate as a decimal
Step 2 of 22
The real wordsTheory

The loanable funds theory

Loanable funds theoryThe market interest rate is determined by the factors that control the supply of and demand for loanable funds.

The same market can be drawn two ways, and the professor uses both. In funds language, borrowers demand funds and savers supply them. In bond language, the same borrowers supply bonds and the same savers demand bonds.

Demand for bonds is supply of funds. Keep the translation straight or the shifters will look backwards.

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