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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 3 of 22
The real wordsTheory

The four demand shifters

What moves the demand curve for bonds, in the slide's order.

  1. Wealth: in a business cycle expansion with growing wealth, demand for bonds rises; in a contraction it falls
  2. Expected returns, and expected interest rates: a higher expected return on bonds relative to alternatives raises demand
  3. Risk: an increase in the riskiness of bonds causes demand for bonds to fall; a rise in the risk of alternatives raises it
  4. Liquidity: greater liquidity of the bond market raises demand for bonds
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