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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 4 of 22
The real wordsTheory

The three supply shifters

What moves the supply curve of bonds. Fewer of them, and each is a reason someone wants to borrow more.

  1. Expected profitability of investment opportunities: in an expansion, firms have projects to fund, so bond supply rises
  2. Expected inflation: higher expected inflation lowers the real cost of borrowing, so bond supply rises
  3. Government deficit: a larger deficit means more government bonds issued, so bond supply rises

More bonds supplied means the price of bonds falls, and a lower bond price is a higher interest rate.

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