International Finance and Financial Markets

Interest Rate

MBAIB 2020
University of Colombo

MBAIB5214 Lecture V - 04 Oct. 2020

Interest Rate
•Definition of Interest Rate
•Distinction between Policy Interest Rates and Market
Interest Rates
•Term Structure of Interest Rates/Yield Curve
•Channels of Policy interest rates influencing Market
Interest Rates

2
 What is Interest Rate?
• Interest rate is a multifaceted macroeconomic variable, associated with multiple
dimensions
• Interest rate is the “Cost of Funds”
• Two Interest Rates: Real and Nominal
“Real interest rate is the nominal interest rate adjusted for inflation”
r = i − 𝞹


i : nominal interest rate

r :real interest rate

𝞹 : rate of inflation
 The Fisher Effect
• The nominal interest rate is the sum of the real interest rate and the inflation rate

i=r+𝞹 (Fisher Equation)

• The nominal interest rate can change for two reasons: because the real interest rate changes or
the inflation rate changes
• The quantity theory of money shows that the rate of money growth determines the rate of
inflation (∆ P% = ∆ M% - ∆ Y%)
• The quantity theory and the Fisher equation together tell us how money growth affects the
nominal interest rate
An increase in the rate of money growth of 1 percent causes a 1 percent increase in the rate of inflation. According to
the Fisher equation, a 1 percent increase in the rate of inflation in turn causes a 1 percent increase in the nominal
interest rate

• The one-for-one relation between the inflation rate and the nominal interest rate is called the
Fisher effect
Distinction between Policy Interest Rates and Market
Interest Rates

• Policy interest rates are set by the monetary authority/Central Bank and depends
on its stance in line with the current and future development in the economy and
financial markets

• Market interest rates are determined by the market forces which reflect the
demand and supply conditions of the liquidity

• Short term liquidity situations : Money market

• Long term liquidity situation : Loanable funds market



Term Structure of Interest rates or the Yield Curve 




Yield Rate = r
Yield Curve

Inverted Yield Curve

0
Time to maturity = t
The Supply and Demand for Loanable Funds
• The interest rate adjusts to bring

Real Interest Rate = r

saving and investment into balance.
The upward-sloping line represents
Savings (S)
saving; the supply of loanable
funds. The downward-sloping line
represents investment; the demand
for loanable funds. The intersection
of these two curves determines the
equilibrium interest rate
Equilibrium
interest rate

Desired investment, I(r)

0
Investment, Saving, I, S


Theories of the Term Structure of Interest rate


 • Expectations Hypothesis
• Investors make decisions based upon a forecast of future interest rates. The theory uses long-term rates,
typically from government bonds, to forecast the rate for short-term bonds. In theory, long-term rates
can be used to indicate where rates of short-term bonds will trade in the future

• Segmentation Hypothesis

• Short term and long term interest are not related to each other and determined independently according
to individual market conditions. It also states that the prevailing interest rates for short, intermediate,
and long-term bonds should be viewed separately like items in different markets for debt securities

• Preferred Habitat Theory

• Short term and long term interest are interrelated. Investors have a preference for short-term bonds over
long-term bonds unless the latter pay a risk premium. In other words, if investors are going to hold onto
a long-term bond, they want to be compensated with a higher yield to justify the risk of holding the
investment until maturity
Lecture 6 - Outline

• External Sector of the Economy

• Balance of Payments and International Financial Flows
• Relationship between the Domestic Financial System and
International Financial System
• Financial Systems in a Globalized Economic Environment