Financial Markets and Institutions

Class 7 – Reflection Paper

Anindita Saha, Roll: 002, BBA-28
February 22, 2023

Movements in the overall economy’s interest rate is usually reflected in a particular asset’s
interest rate.
Securities’ Yield = Real Rate of Interest + Inflation Premium + Risk Premium
Real rate of interest and inflation premium are directly influenced by the overall economy’s
interest rate. In fact, majority of the total interest rate on a particular security comes from
these two.
6 types of risks:
1. Default risk
2. Reinvestment risk
3. Interest rate risk
4. Maturity risk
5. Exchange rate risk
6. Liquidity risk
Risk premium would include compensation for all of these types of risks as applicable for
individual securities.
Increase in inflation causes investors to become dissatisfied with the current return generated
by the securities they have invested in. They sell off these securities, which causes a hike in
supply of the securities and a decline in the price of those securities. Since market price and
return received on a security have an inverse relationship, this in reality means the security’s
yield increases until it matches market expectation.
In the market for loanable funds, households, businesses and governments can become the
deficit unit demanding loans.
Governments usually demand funds when they face budget deficits. This causes demand of
loanable funds curve to shift outward and results in a higher interest rate. To tackle this surge
of interest rate, government often increases money supply in the economy.
High interest rates often cause crowding out effect, that is riskier business which generate
higher returns than what is reasonable turn out to be the only who can borrow at such rates.
High interest rates also cause unemployment as business layoff/reduce hiring due to fund
crisis.
Superior economic growth is usually accompanied by high inflation. This is because if such
economic growth exists, it indicates that business are borrowing more and more, which
causes the aggregate demand of loanable funds to increase and thus causes a surge in interest
rates. To control such interest hikes, governments increase money supply, which in turn cause
high inflation to sustain in the economy.
An increase in the supply of securities indicates an increase in the demand for loanable funds.
An increase in the demand of securities indicates an increase in the supply of loanable funds.
Slope of the loanable fund supply curve is lower, that is the curve is steeper because the
supply of loanable funds is usually controlled by the government. The loanable fund supply
curve is more elastic as major demanders are usually households and businesses.