Introduction to Finance Markets

Investments and Financial Management

14th Edition Melicher Solutions Manual
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 Chapter Eight: Interest Rates

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Chapter 8
Interest Rates

CHAPTER PREVIEW

Lenders charge an “interest rate” on money they “loan” to individuals and businesses.
Borrowers pay an “interest rate” on money “lent” to them for a specified time period.
Interest rates are determined by the supply and demand for loanable funds that exist at a point
in time. We describe the determinants of nominal or market interest rates which include an
inflation premium, a default risk premium, and a maturity risk premium. We follow with a
description of the characteristics of U.S. Treasury debt obligations which are considered by
most individuals to be free of default risk. Our attention then turns to coverage of the term or
maturity structure of interest rates and why interest rates generally increase as maturities or
lives of debt instruments lengthen. This will be followed by a discussion of past inflation
premiums and price movements. Our last topic in the chapter addresses default risk
premiums or the “quality” of bonds issued by the government and by corporations.
To develop student interest, you may have students prepare a table showing changes in
the term structure of interest rates and default risk premiums over the last several years. Such
data can be found on the Federal Reserve Bank of St. Louis website at
http://www.stlouisfed.org. Discussion time can profitably be devoted to possible reasons for
any changes in each of the series and their interrelationships. Students also may be assigned a
report in which they use the consumer price index to update Figure 8.3. Class discussion
can be generated by asking students to write reports that examine past periods of high
inflation.

LEARNING OBJECTIVES

• Describe how interest rates change in response to shifts in the supply and demand for
loanable funds.
• Identify major historical movements in interest rates in the United Sates.
• Describe the loanable funds theory of interest rates.
• Identify the major determinants of market interest rates.
• Describe the types of marketable securities issued by the U.S. Treasury.
• Describe the ownership of Treasury securities and the maturity distribution of the federal
debt.
• Explain the term or maturity structure of interest rates.
• Identify and briefly describe the three theories used to explain the term structure of
interest rates.
• Identify broad historical price level changes in the United States and other economies
and discuss their causes.
• Describe the various types of inflation and their causes.
• Discuss the effect of default risk premiums on the level of long-term interest rates.
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CHAPTER OUTLINE
I. SUPPLY AND DEMAND FOR LOANABLE FUNDS
A. Historical Changes in U.S. Interest Rate Levels
B. Loanable Funds Theory
1. Sources of Loanable Funds
2. Factors Affecting the Supply of Loanable Funds
a. Volume of Savings
b. Expansion of Deposits by Depository Institutions
c. Liquidity Attitudes
3. Effect of Interest Rates on the Demand for Loanable Funds
4. Roles of the Banking System and of the Government
5. International Factors Affecting Interest Rates

II. DETERMINANTS OF MARKET INTEREST RATES

III. RISK-FREE SECURITIES: U.S. TREASURY DEBT OBLIGATIONS

A. Marketable Obligations
1. Treasury Bills
2. Treasury Notes
3. Treasury Bonds
B. Dealer System
C. Tax Status of Federal Obligations
D. Ownership of Public Debt Securities
E. Maturity Distribution of Marketable Debt Securities

IV. TERM OR MATURITY STRUCTURE OF INTEREST RATES

A. Relationship between Yield Curves and the Economy
B. Term Structure Theories

V. INFLATION PREMIUMS AND PRICE MOVEMENTS

A. Historical Price Movements
1. Ancient Rome
2. The Middle Ages Through Modern Times
B. Inflation in the United States
1. Revolutionary War
2. War of 1812
3. Civil War
4. World War I
5. World War II and the Postwar Period
6. Recent Decades
C. Types of Inflation
1. Price Changes Initiated by a Change in Costs
2. Price Changes Initiated by a Change in the Money Supply
3. Speculation and Administrative Inflation

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VI. DEFAULT RISK PREMIUMS

VII. SUMMARY

LECTURE NOTES

I. SUPPLY AND DEMAND FOR LOANABLE FUNDS

The supply and demand for loanable funds will take place as long as both lenders and
borrowers have the expectation of satisfactory returns. Figure 4.1 can be used to
graphically show how interest rates are determined in the financial markets. Supply
and demand for loanable funds as of a particular point in time establish an equilibrium
interest rate level. Interest rates may move from an equilibrium level if an
unanticipated change or shock (e.g., higher rate of inflation) occurs that will cause the
demand for, or supply of, loanable funds to change.
The loanable funds theory (referred to as a flow theory) holds that interest rates
are a function of the supply of and demand for loanable funds. Factors affecting the
supply of loanable funds include: volume of savings, expansion of credit by
depository institutions, and liquidity attitudes. Since the Civil War, there have been
four periods of rising or relatively high long-term interest rates and three periods of
low or falling interest rates on long-term loans and investments.
(Use Figure 8.1 and Discussion Questions 1 through 6 here.)

II. DETERMINANTS OF MARKET INTEREST RATES

In addition to supply and demand relationships, interest rates (r) are determined by:
the real rate of interest (RR); an inflation premium (IP); a default risk premium
(DRP); a maturity risk premium (MRP); and a liquidity premium (LP). In equation
form, we have: r = RR + IP + DRP + MRP + LP.
The real rate of interest is the interest rate on a risk-free financial debt instrument.
The inflation premium is the average inflation rate expected over the life of the debt
instrument. The default risk premium indicates compensation for the possibility that the
borrower will not pay interest and/or repay principal according to the financial
instrument’s contractual arrangements. The maturity risk premium is the added return
expected by lenders or investors because of interest rate risk (possibility of fluctuations
in market values due to market interest rate changes) on instruments with longer
maturities. The liquidity premium is compensation for those financial debt instruments
that cannot be easily converted to cash at prices close to their estimated fair market
values.
(Use Discussion Question 7 here.)

III. RISK-FREE SECURITIES: U.S. TREASURY DEBT OBLIGATIONS

The obligations of the federal government are so vast that they now dominate both
short-term and long-term capital markets. They play an important role in the
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investment patterns of most financial institutions. While interest received from federal
obligations is subject to federal taxes, it is not taxable by state and municipal
authorities. Because federal obligations are the highest quality available, all other
obligations must provide yields scaled above those of the government. Only the yields
on municipal obligations are lower due to their interest exemption from federal taxes
rather than their quality. Students may look up these yield spreads in The Wall Street
Journal, in other financial publications, or by accessing various Federal Reserve Bank
Web sites.
The obligations of the federal government are broadly classed as marketable and
nonmarketable. Marketable obligations such as Treasury bills (having the shortest
maturities), Treasury notes, and Treasury bonds constitute the bulk of total
obligations. Nonmarketable obligations are represented primarily by U.S. savings
bonds. A recent issue of the Treasury Bulletin may be used to determine the relative
magnitude of the various types of obligations. This information also may be obtained
from the Treasury’s Web site.
Outstanding issues of federal obligations are traded actively in the nation’s
secondary bond markets. A select group of dealers, made up of both large commercial
banks and nonbank institutions, dominate this secondary market. The dealers buy and
sell securities for their own account, arrange transactions with both their customers
and other dealers, and also purchase debt directly from the Treasury for resale to
investors.
(Use Discussion Questions 8 through 11 here.)
The very magnitude of the federal debt means that obligations representing that
debt play a role in most investment portfolios. Ownership by individual groups is
shown in Table 8.1. Of special interest is the importance of government agencies and
trust funds. Foreign and international investors currently own about 21% of federal
debt securities. While continued accumulation by government agencies can be
assumed, continued foreign and international investment in federal obligations
depends on their appeal. The U.S. Treasury has become dependent on foreign
purchases of its obligations. These foreign investors have a special interest in the
efforts of this nation to achieve a balanced budget.
(Use Table 8.1 and Discussion Question 12 here.)
Table 8.2 provides a picture of the maturity distribution of the federal debt. Short-
term obligations (within a 1 year maturity) account for over one-third of the
outstanding marketable interest-bearing federal obligations. This category, coupled
with the 1–5 years category, account for about two-thirds of the outstanding federal
debt. From the end of World War II, the average maturity of the debt declined
dramatically until it reached a low of 2 years and 5 months in 1975. The average
maturity then increased and was an even 6 years in 1989. By 2000, the average
maturity declined slightly down to 5 years and 10 months. The average maturity at the
end of 2003 was 5 years and 1 month, 4 years and 9 months by the end of 2006, and
had dropped to 3 years and 10 months by November, 2008. Refunding is now much
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more flexible and can be carried out at the times and in a manner that the financial
markets are least disturbed.
(Use Table 8.2 and Discussion Questions 13 and 14 here.)

IV. TERM OR MATURITY STRUCTURE OF INTEREST RATES

The term structure of interest rates refers to the impact of debt maturities on interest
rates. The term structure is shown graphically in terms of yield curves, which are
constructed by graphing yields on debt securities with comparable default risk against
their maturities as of a specific point in time.
Three theories are used to explain the term structure of interest rates: expectations
theory, liquidity premium theory, and market segmentation theory. The expectations
theory reflects investor expectations about future short-term and long-term inflation
rates. If inflation rates are expected to be the same across all maturities, then the yield
over time on short-term securities is expected to be the same as the current rate on
long-term securities.
Under the liquidity premium theory, investors are willing to trade off some yield
for the greater liquidity that is inherent in short-term securities. Thus, the yield curve
is expected to be upward sloping.
The market segmentation theory contends that securities with different maturities
are less than perfect substitutes for each other. Thus, the yield curve is influenced by
institutional pressures.
(Use Figure 8.2, Table 8.3, and Discussion Questions 15 and 16 here.)

V. INFLATION PREMIUMS AND PRICE MOVEMENTS

Wide swings in prices are not a recent phenomenon. Earliest records refer to them,
giving testimony to the importance attached to the subject throughout the ages.
The ancient Roman Period is often cited because of the availability of historical
records of the events that led to wide price swings. The large quantities of gold and
other precious metals brought to Rome as a result of conquests in Egypt gave rise to
increasing prices and interest rates. The use of precious metals as money meant an
increase in the money supply relative to the supply of goods and services—hence,
there was inflation. Nero’s debasements of gold and silver coins were numerous and,
as history reveals, irreversible. During the Middle Ages, debasement of coinage was
frequently used as a source of revenue for princes and kings, particularly in France.
Records indicate that debasement often provided greater revenues for French rulers
than any other source.
Spain brought back huge supplies of gold and silver from Mexico and Peru and, as
in Rome, prices increased as the circulating money supply (precious metals) increased.
With its huge stores of precious metals, Spain was able to purchase goods from other
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countries that had not been equally affected by price increases. This led to a decline in
Spain’s domestic productivity. Once its precious metals were spent, Spain was left
with an economy ill prepared to compete against other countries that had benefited
from productivity increases.
Inflation was somewhat restrained during World War I, but shortly thereafter (in
1923) Germany experienced one of the wildest periods of inflation in history. Inflation
was again somewhat restrained during World War II except in certain countries—for
example, China and Hungary, where runaway inflation occurred.
(Use Discussion Questions 17 and 18 here.)
Although peacetime swings in price levels are common, the principal movements
are those during or after wars. The Revolutionary War, which brought this nation into
existence, was financed by inflation. Without authority to levy taxes, the Second
Continental Congress issued notes in ever increasing amounts until they were virtually
worthless. The phrase “not worth a continental” became a part of the American
language.
The War of 1812 was financed by issuing bonds of small denomination bearing no
interest and having no maturity date. Prices went up and a depression followed. The
Civil War was financed, in part, through the issuance of paper money called
“greenbacks.” Inflation resulted and post-war attempts to retire the greenbacks
resulted in depression. Greenbacks continue to circulate to this day, but they are
mainly collectors’ items.
About two-thirds of the total cost of World War I was financed by heavy
borrowing, much of it from the banking system. Prices rose and then dropped
following the war. During World War II, attempts were made to avoid inflationary
finance through price control mechanisms. Nevertheless, huge sums were borrowed
from the banking system and from the sale of savings bonds to individuals. When the
controls were lifted after the war, inflation resulted.
Prices rose during the Korean War; they rose again during the 1955–1957 period
of expansion in economic activity following the 1954 recession. During the buildup of
the Vietnam War, prices increased somewhat, but following that conflict they rose at
the highest rate since World War I. While inflation in the U.S. during the mid-1970s
was intense as a result of the oil crisis in the Middle East, inflationary pressures were
even greater in many other industrial countries.
As the 1970s ended, the general public became cynical about prospects for
controlling inflation—they simply built inflation into their expectations. One result
was extremely high nominal interest rates as investors attempted to protect fixed
income investments from declining purchasing power. Monetary restraint was
exercised in 1980, which quickly led to a depressing effect on the economy. This
restraint was then abandoned and monetary stimulus drove interest rates to new peaks.
The Reagan administration reversed the monetary stimulus and a decline in the
economy quickly followed. By the end of 1982, economic recovery was back in place
and the back of inflation had been broken. Throughout the first decade of the twenty
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first century, inflation remained at historically low levels. For example, see Figure
8.3.
(Use Figure 8.3 and Discussion Questions 19 and 20 here.)
The price level can, at times, increase without changes in the money supply or
velocity, if costs increase faster than productivity. These costs will eventually be
passed on to consumers in the form of higher prices. This type of inflation is referred
to as cost-push inflation. This distinguishes it from inflation due to an increase in the
money supply, which is called demand-pull inflation. In practice, both aspects of
inflation are likely to be operative at the same time. Inflation may also be initiated by
especially large changes in demand in certain industries.
Inflation caused by increased money supply can lead to additional price pressure,
referred to as speculative inflation. When prices have risen for some time, it is
generally accepted that they will keep on rising. This may prove self-fulfilling for a
time. Instead of higher prices resulting in decreased demand, people may buy more to
stock up on goods before they get even more expensive. This happened in the late
1970s.
For at least three decades, inflation has generally persisted, giving rise to belief in
a long-run inflationary bias in the economy. Prices and wages tend to rise during
periods of rapid economic expansion. Wage contracts that have escalator clauses to
keep wages in line with prices are very effective, but at times these contracts result in
wage increases greater than productivity increases. Further, the wage increases are
fixed and do not decline during subsequent economic contractions. In effect, there is a
sort of ratchet effect—a level of costs remaining high prevents prices from declining.
The U.S. government typically takes action to relieve unemployment problems long
before the ultimate effect of a prolonged recession can take effect. Large corporations
tend to rely on nonprice competition rather than cut prices. These and other factors
provide the basis for a long-run inflationary bias. However, inflation remained at
historically low levels as of the beginning of the twenty first century.
(Use Discussion Questions 21 through 23 here.)

VI. DEFAULT RISK PREMIUMS

We focus on the capital markets when discussing long-run inflation expectations and
interest rate differentials between securities. The risk-free rate (as represented by the
rate on long-term Treasury securities) is comprised of a real return component and a
long-run inflation expectations component. Default risk is the probability that the
issuer of a security will fail to make interest or principal payments. The difference
between the risk-free rate and the interest rate on a risky corporate bond is referred to
as the default risk premium.
Default risk premiums indicate the degree of investor pessimism or optimism
about economic expectations as of a point in time. Investors require relatively higher
premiums to compensate for default risk when the economy is in a recession or is
expected to enter one. This is because more firms fail or suffer financial distress
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during periods of recession compared with periods of economic expansion. Students

might be asked to update the default risk premiums information contained in Table 8.4
in order to facilitate discussion and enhance their understanding,
(Use Table 8.4 and Discussion Questions 24 and 25 here.)

DISCUSSION QUESTIONS AND ANSWERS

1. What is meant by the term “interest rate,” and how is it determined?

The term interest rate is the price that equates the demand for and supply of loanable
funds. An equilibrium interest rate is established when the demand by borrowers for
funds equals the supply of funds by lenders.
2. Describe how interest rates may adjust to an unanticipated increase in inflation.
Interest rates may move from an equilibrium level if an unanticipated change or “shock”
occurs that will cause the demand for, or supply of, loanable funds to change. Graph C
in Figure 8.1 can be used to illustrate the impact of an unanticipated increase in
inflation. Lenders (suppliers) immediately require a higher rate of interest. This is
shown by an upward shift in the supply curve for a given level of demand for loanable
funds. This shift causes the interest rate (r) to increase or rise.
3. Identify major periods of rising interest rates in U.S. history and describe some of the
underlying reasons for these interest rate movements.
The first period of rising interest rates was from 1864 to 1873 and was based on the
rapid economic expansion during the period following the Civil War. The second
period, from 1905 to 1920, was based on large-scale prewar expansion and after 1914
on the inflation associated with World War I. The third period, from 1927 to 1933, was
due to the boom from 1927 to 1929 and the unsettled conditions in the securities
markets during the early years of the depression, from 1929 to 1933. The fourth period,
from 1946 to 1982, was based on the rapid expansion in the period following the end of
World War II; the Vietnam War; and in the 1970s to dislocations associated with
various wage and price controls, costs associated with increased ecological concerns,
and rapidly rising energy costs. Rates have been in a general downward trend since
early 1982.
4. How does the loanable funds theory explain the level of interest rates?
The loanable funds theory holds that interest rates are a function of the supply of and
demand for loanable funds. It is viewed as a “flow” theory in that it focuses on the
relative supply and demand of loanable funds during a specified time period. If the
supply of funds increases, holding demand constant, interest rates will tend to fall.

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Likewise, an increase in the demand for loans will tend to drive up interest rates. Figure
8.1 contains graphical relationships involving the impact of changes in supply and
demand from an equilibrium level.
5. What are the main sources of loanable funds? Indicate and briefly discuss the factors
that affect the supply of loanable funds.
The two basic sources are current savings and the creation of new funds through the
expansion of credit by depository institutions. The major determinant in the long run of
the volume of savings, corporate as well as individual, is the level of national income.
Also important is the pattern of income taxes, life cycle stages, and factors that affect
indirect savings in the form of life insurance and pension plans. In addition, interest rate
changes have a lag effect on savings associated with the use of consumer credit.
The availability of short-term credit depends upon commercial bank and other
depository institution lending policies and upon Federal Reserve policies that affect
them. The availability of long-term credit of different types depends upon the policies of
the many different suppliers of credit.
Liquidity attitudes are also important. Liquidity attitudes are a significant factor, at
times, in determining the available supply of loanable funds, both long-term and short-
term, relies on the attitude of lenders regarding the future. For example, it is possible
that liquidity attitudes may result in the holding of some funds idle that would normally
be available for lending because of uncertainty about the outlook for the economy.
6. Indicate the sources of demand for loanable funds and discuss the factors that affect the
demand for loanable funds.
The demand for loanable funds comes from all sectors of the economy. Businesses
borrow to finance current operations and to buy plants and equipment. Farmers borrow
to meet short-term and long-term needs. Institutions such as hospitals and schools
borrow primarily to finance new buildings and equipment. Individuals borrow on a
long-term basis to finance the purchase of homes, and on an intermediate- and short-
term basis to purchase durable goods or to tide them over through emergencies.
Governmental units borrow to finance public buildings, to bridge the gap between
expenditures and tax receipts, and to meet budget deficits.
The effect of interest rates on the demand for various types of credit is summarized
in the chapter.
7. What are the factors, in addition to supply and demand relationships, that determines
market interest rates?
Interest rates (r) are determined by the real rate of interest (RR), an inflation premium
(IP), a default risk premium (DRP), a maturity risk premium (MRP), and a liquidity
premium (LP) in addition to supply and demand relationships. The real rate of interest is
the interest rate on a risk-free debt instrument. The inflation premium is the average
inflation rate expected over the life of the debt instrument. The default risk premium
indicates compensation for the possibility that the borrower will not pay interest and/or
repay principal according to the contractual arrangements. The maturity risk premium is
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the added return expected by lenders or investors because of the possibility of

fluctuations in debt values due to market interest rate changes (i.e., interest rate risk) on
instruments with longer maturities. The liquidity premium is compensation for those
financial debt instruments that cannot be easily converted to cash at “fair” market prices.
8. What are the types of marketable obligations issued by the Treasury?
Marketable government securities, as the term implies, are those that may be purchased
and sold through customary market channels. Treasury bills bear the shortest maturities
of federal obligations. They are typically issued for 91 days but also are issued with a
maturity of up to one year. Treasury bills are issued on a discount basis and mature at
par. Treasury notes, referred to as intermediate-term federal obligations, are issued at
specific interest rates with maturities of more than one year but not more than 10 years.
Treasury bonds generally have an original maturity in excess of five years (the longest
maturity is 30 years). These bonds bear interest at stated rates.
9. Explain the mechanics of issuing Treasury bills, indicating how the price of a new issue
is determined.
Treasury bills are issued on a discount basis and mature at par. Each week the Treasury
bills to be sold are awarded to the dealers and other investors who submit the highest
bids. When the sealed bids are opened, they are arrayed from highest to lowest; that is,
those bidders asking the least discount (offering the highest price) are placed high in the
array. The bids are then accepted in the order of their position in the array until all bills
are awarded. Bidders seeking a high discount (and offering a low price) may fail to
receive any bills that particular week. Investors interested in purchasing small volumes
of Treasury bills ($10,000 to $500,000) may submit their orders on an “average
competitive price” basis. The Treasury deducts these small orders from the total volume
of bills to be sold. After the bills are allotted on the competitive basis described above,
the smaller orders are then executed at a discount equal to the average of the
competitive bids accepted for the large orders.
10. Describe the dealer system for marketable U.S. government obligations.
A select group of about 40 to 50 commercial bank and nonbank dealers buy and sell
securities for their own account and arrange transactions with both their customers and
other dealers. New dealers are added to this select group only when they can
demonstrate satisfactory responsibility and volume of activity. These large-volume
dealers are designated by, and report their activity daily to, the Federal Reserve Bank of
New York.
11. What is meant by the tax status of income from federal obligations?
The interest on all federal obligations is now subject to ordinary federal income taxes
and tax rates. Income from the obligations of the federal government is exempt from all
taxing authority of state and local governments. Federal bonds, however, are subject to
both federal and state inheritance, estate, or gift taxes.
12. Describe any significant changes in the ownership pattern of federal debt securities in
recent years.
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The government made a special effort following World War II to increase the nonbank
ownership of the federal debt, with emphasis on an increase in individual ownership. In
addition to increased individual ownership, nonbank corporations, state and local
governments, and foreign investors have dramatically increased their ownership of the
debt. Ownership of the federal debt is shown in the Economic Report of the President
and can be obtained from the Federal Reserve Bank of St. Louis at
http://www.stlouisfed.org. Since these publications show ownership for several years,
evolving changes in ownership are easily observed.
13. What have been the recent developments in the maturity distributions of marketable
interest-bearing federal debt?
After reaching a low level of two years and five months in late 1975, the maturity
distribution of marketable interest-bearing debt increased to five years and ten months in
2000. The average maturity at the end of 2003 was five years and one month and down
to four years and nine months at the end of 2006. As of November 2008, the average
maturity was three years and ten months (see Table 8.2).
14. Describe the process of advance refunding of the federal debt.
Advance refunding occurs when the Treasury offers owners of a given issue the
opportunity to exchange their holdings well in advance of their regular maturity for new
securities of longer maturity. This “leap-frogging” of maturities was begun in 1960.
15. What is the term structure of interest rates and how is it expressed?
The term structure of interest rates refers to the impact of loan maturities on interest
rates. This is often expressed with a “yield curve,” which includes securities of
comparable risk and plots yields against maturities as of a particular point in time.
16. Identify and describe the three basic theories used to explain the term structure of
interest rates.
The three basic theories to explain term structure of interest rates are:
a. Expectations theory: This theory reflects investor expectations about future short-
term and long-term inflation rates. The long-term interest rates at any point in time
reflect the average of the prevailing short-term interest rates plus short-term interest
rates expected in the future. If inflation rates were expected to be the same across all
maturities, the yield curve would be expected to be flat across different maturities.
b. Liquidity premium theory: Because of future uncertainty, liquidity should warrant a
premium. Thus, associated supply-and-demand pressures should cause short-term
rates to be lower than long-term rates, making the yield curve upward sloping.
c. Market segmentation theory: Securities of different maturities are less than perfect
substitutes for each other and supply-and-demand factors in each market influence
various segments of the yield curve.
17. Describe the process by which inflation took place before modern times.

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Inflation took place, at times, because the money supply increased when gold or silver
hoards were seized during a war or foreign lands were colonized. The most frequent
form of inflation was the debasement of coins.
18. Discuss the early periods of inflation based on the issue of paper money.
The first outstanding example of this type of inflation was in France, where John Law
was given a charter in 1719 for a bank that could issue paper money. Paper money was
also issued in excessive quantities during the American Revolutionary War and the
French Revolution.
19. What was the basis for inflation during World Wars I and II?
Inflation during World War I was widespread because the money supply was increased
to finance the war, but it was held in check to some degree by government action. The
most spectacular inflation took place in Germany after the war when in 1923 prices
soared to astronomical heights. The money supply was increased to some extent to
finance World War II, but attempts to control inflation met with some success. Runaway
inflation occurred, however, especially in China and Hungary.
20. Discuss the causes of the major periods of inflation in American history.
Revolutionary War: issuance of excessive supplies of paper money and lack of
confidence in the financial stability of the government
War of 1812: issuance of paper currency
Civil War: issuance of paper currency
World Wars I and II: sale of bonds to the banking system
Post-World War II period: increase in the cost of production due to increases in the
amounts paid to the factors of production, which were greater than increases in
productivity; also, increased bank credit
Vietnam War and postwar period: rapid increase in government expenditures financed
in part by deficits; devaluation of the dollar, first by 12 percent and then by 10 percent;
poor crops in many parts of the world and drought in the Midwest in 1974; Arab oil
embargo and increases in the price of crude oil by oil exporting countries
21. Explain the process by which price changes may be initiated by a general change in
costs.
If costs increase faster than productivity increases, they may be passed on to consumers.
Costs of basic raw materials may also go up faster than the general price level in
industries in which demand is in excess of supply. Until the economy is at a level of full
utilization of resources, there will be increased prices and profits and, in turn, there will
be a demand for wage increases, in sectors of the economy in which administered prices
exist. The wage increases may spur unions in other industries to ask for similar
increases. This is especially true if government deficits are used to stimulate economic
activity in periods of recession.
22. How can a change in the money supply lead to a change in the price level?

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When resources are fully utilized, a change in the money supply increases money
demand. Since supply cannot go up, prices rise. Prices will generally also rise during
expansion before resources are fully utilized. This is true because bottlenecks appear in
some sectors of the economy and because prices rise in expectation of the full use of
resources. Prices also rise because there is a desire to establish a new balance between
the desire to hold money and other assets; this leads to an increase in investment and in
the demand for goods. The reverse is true if the money supply is reduced.
23. What is meant by the speculative type of inflation?
When prices have risen for some time, the idea that they will keep on rising becomes
widespread. This idea may become self-generating for a time since, instead of higher
prices resulting in decreased demand, people may buy more goods in the belief that
prices will go still higher. This may not happen in all sectors of the economy but, rather,
be confined to certain areas, as it was to land prices in the Florida boom in the 1920s or
to security prices in the 1928–1929 stock market heyday.
24. What is meant by a default risk premium?
Default risk is the risk that a borrower will not pay interest and/or repay the principal on
a loan or other debt instrument according to the agreed contractual terms. It can be
measured as the difference in interest rates between a long-term Treasury bond and a
specified long-term corporate bond.
25. How can a default risk premium change over time?
Default risk premiums change with changes in investor pessimism or optimism about
economic expectations. Since more firms fail or suffer financial distress during
recessions, default risk premiums increase as the expectation of a recession increases.

EXERCISES AND ANSWERS

1. Go to the Federal Reserve Bank of St. Louis website at http://www.stlouisfed.org, and

find interest rates on U.S. Treasury securities and on corporate bonds with different
bond ratings.
a. Prepare a yield curve or term structure of interest rates.
Note: the instructor will need to update the information provided in Table 8.3 and
Figure 8.2.

b. Identify existing default risk premiums between long-term Treasury bonds and
corporate bonds.
Note: the instructor will need to update the information in Table 8.4.

8-13
 Chapter Eight: Interest Rates

2. As an economist for a major bank you are asked to explain the present substantial
increase in the price level, notwithstanding the fact that neither the money supply nor
the velocity of money has increased. How can this occur?
Inflation may be associated with a change in costs, a change in the money supply,
speculation, and administrative pressures. Actually, inflation has been at relatively low
levels in the U.S. in recent years. Inflation can be associated with an increase in the
money supply or the velocity of money (which are ruled-out here). Inflation could be
due to cost-push or demand-pull cost changes, speculation, or administrative pressures.
Costs have not been rising very rapidly in recent years and little speculation has been
taking place. Some administrative inflation may take place. Administrative inflation is
the tendency of prices, aided by union-corporation contracts, to rise during economic
expansion and to resist declines during recessions.
3. As an advisor to the United States Treasury you have been asked to comment on a
proposal for easing the burden of interest on the national debt. This proposal calls for
the elimination of federal taxes on interest received from Treasury debt obligations.
Comment on the proposal.
Municipal (state and local) debt has interest rates that are lower than the interest rates on
Treasury debt because the interest on municipal debt is exempt from federal taxes. The
first most likely reaction to eliminating federal taxes on interest received from Treasury
debt is that the Federal government would sell debt at lower interest rates which would
reflect this tax change. However, tax receipts to the government would also decline
causing the budget deficit to increase. This, in turn, would cause the Treasury to issue
larger amounts of debt securities. The result might be no discernible impact on the size
of the national debt.
4. As one of several advisors to the U.S. Secretary of the Treasury, you have been asked to
submit a memo in connection with the average maturity of the obligations of the federal
government. The basic premise is that the average maturity is far too short. As a result,
issues of debt are coming due with great frequency and needing constant reissue. On the
other hand, the economy is presently showing signs of weakness. It is considered unwise
to issue long-term obligations and absorb investment funds that might otherwise be
invested in employment-producing construction and other private sector support. Based
on these conditions, what do you recommend as a course of action to the U.S. Secretary
of the Treasury?
The lengthening of the maturity structure of the national debt has been a long-standing
problem for the Treasury. A limited number of options are available. Since the condition
in this problem is that the economy is showing signs of weakness, it would be almost
impossible to lengthen the average maturity significantly at this time. The best possible
approach would be to schedule the sale of obligations with a spread of maturities—that
is, some short, some intermediate, and a small amount of long-term maturities. When
the economy shows renewed strength, the volume of obligations sold on a long-term
basis can be increased. Further, advance refunding of outstanding issues can be utilized
at such a time.

8-14
 Chapter Eight: Interest Rates

5. Assume a condition in which the economy is strong, with relatively high employment.
For one reason or another, the money supply is increasing at a high rate and there is
little evidence of money creation slowing down. Assuming the money supply continues
to increase, describe the evolving effect on price levels.
Although the parallel between the money supply growth rate and prices seems to no
longer exist, it is generally acknowledged that there is some relationship. It is assumed
that if the money supply increases faster than the supply of goods, prices must rise in
response to the supply/demand situation. When the money supply increases, we are
inclined to spend more as our cash balances exceed our desired levels. In due time, the
increase in spending is reflected in increasing prices as production levels reach their
limits.

6. Assume you are employed as an investment advisor. You are working with a retired
individual who depends on her income from her investments to meet her day-to-day
expenditures. She would like to find a way of increasing the current income from her
investments. A new junk bond issue has come to your attention. If you sell these high-
yield bonds to a client, you will earn a higher than average fee. You wonder whether
this would be a win-win investment for your retired client, who is seeking higher
current income, and for you, who would benefit in terms of increased fees. What would
you do?

High yield or junk bonds are considered to be high risk with potential loss of interest
and/or principal. Preservation of financial capital usually is of primary emphasis to
retired individuals with income usually being secondary. It would be unethical (and
possibly illegal) not to explain the risk associated with investing in junk bonds to the
retired individual. While there is an opportunity for a higher return, there is also
substantial risk in the form of possible loss of interest and the possibility that the bond
principal may not be repaid at maturity.

PROBLEMS AND ANSWERS

1. Assume investors expect a 2.0 percent real rate of return over the next year. If inflation
is expected to be 0.5 percent, what is the expected nominal interest rate for a one-year
U.S. Treasury security?

r = RR + IP = 2.0% + 0.5% = 2.5%

2. A one-year U.S. Treasury security has a nominal interest rate of 2.25 percent. If the
expected real rate of interest is 1.5 percent, what is the expected annual inflation rate?

r = RR + IP
IP = r – RR = 2.25% - 1.5% = 0.75%

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 Chapter Eight: Interest Rates

3. A ten-year U.S. Treasury bond has a 3.50 percent interest rate, while a same maturity
corporate bond has a 5.25 percent interest rate. Real interest rates and inflation rate
expectations would be the same for the two bonds. If a default risk premium of 1.50
percentage points is estimated for the corporate bond, determine the liquidity premium
for the corporate bond.

r = RR + IP + DRP + MRP + LP,

Where the DRP exists for a corporate bond.
RR and IP are the same for both bonds. There is no MRP because both bonds have equal
10-year maturities.
Thus, LP = r corporate bond – r treasury bond – DRP = 5.25% - 3.50% - 1.50% = 0.25%

4. A thirty-year U.S. Treasury bond has a 4.0 percent interest rate. In contrast, a ten-year
Treasury bond has an interest rate of 3.7 percent. If inflation is expected to average 1.5
percentage points over both the next ten years and thirty years, determine the maturity
risk premium for the thirty-year bond over the ten-year bond.

r = RR + IP + DRP + MRP + LP
RR and IP are the same for both bonds and there is no DRP or LP.
Thus, MRP = r 30-year Treasury – IP) – (r 10-year Treasury – IP) = (4.0% - 1.5%) –
(3.7% - 1.5%) = 2.5% - 2.2% = 0.3%
Or, MRP = r 30-year Treasury – r10-year Treasury = 4.0% - 3.7% = 0.3%

5. A thirty-year U.S. Treasury bond has a 4.0 percent interest rate. In contrast, a ten-year
Treasury bond has an interest rate of 2.5 percent. A maturity risk premium is estimated
to be 0.2 percentage points for the longer maturity bond. Investors expect inflation to
average 1.5 percentage points over the next ten years.

a. Estimate the expected real rate of return on the ten-year U.S. Treasury bond.

r = RR + IP + MRP
RR = r – IP – MRP
RR 10-year Treasury = 2.5% -1.5% - 0.0% = 1.0%

b. If the real rate of return is expected to be the same for the thirty-year bond as for the
ten-year bond, estimate the average annual inflation rate expected by investors over
the life of the thirty-year bond.

r = RR + IP + MRP
If RR was 1.0% from Part (a) for the 10-year Treasury, then RR is 1.0% also for the
30-year bond.
IP = r 30 year bond- r 10-year bond – RR - MRP = 4.0% - 2.5% - 1.0% - 0.2% =
0.3%

6. You are considering an investment in a one-year government debt security with a yield of

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 Chapter Eight: Interest Rates

5 percent or a highly liquid corporate debt security with a yield of 6.5 percent. The
expected inflation rate for the next year is expected to be 2.5 percent.

a. What would be your real rate earned on either of the two investments?

Government debt rate = real rate + inflation premium

Real rate = 5% - 2.5% = 2.5%

b. What would be the default risk premium on the corporate debt security?

Risky debt rate = government debt rate + default risk premium

Default risk premium = 6.5% - 5% = 1.5%

7. Inflation is expected to be 3 percent over the next year. You desire an annual real rate of
return of 2.5 percent on your investments.

a. What nominal rate of interest would have to be offered on a one-year Treasury

security for you to consider making an investment?

Government debt rate = real rate + inflation premium

Government debt rate = 2.5% + 3% = 5.5%

b. A one-year corporate debt security is being offered at 2 percentage points over the
one-year Treasury security rate that meets your requirement in (a). What would be
the nominal interest rate on the corporate security?

Corporate debt rate = government debt rate + default risk premium

Corporate debt rate = 5.5% + 2% = 7.5%

8. Find the nominal interest rate for a debt security given the following information: real
rate = 2%, liquidity premium = 2%, default risk premium = 4%, maturity risk premium
= 3%, and the inflation premium = 3%.
Nominal Interest Rate (r) = Real Rate (RR) + Inflation Premium (IP)
r = 2% + 3% = 5%
9. Find the default risk premium for a debt security given the following information:
inflation premium = 3%, maturity risk premium = 2.5%, real rate = 3%, liquidity
premium = 0%, and the nominal interest rate is 10%.
r = RR + IP + DRP + MRP + LP
DRP = r – RR – IP – MRP – LP
DRP = 10% – 3% – 3% – 2.5% – 0% = 1.5%
10. Find the default risk premium for a debt security given the following information:
inflation premium – 2.5 percent, maturity risk premium = 2.5 percent, real rate = 3
percent, liquidity premium = 1.5 percent, and nominal interest rate = 14 percent.
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 Chapter Eight: Interest Rates

r = RR + IP + DRP + MRP + LP
DRP = r – RR – IP – MRP – LP
DRP = 14% – 3% – 2.5% – 2.5% – 1.5% = 4.5%

11. Assume that the interest rate on a one-year Treasury bill is 6 percent and the rate on a
two-year Treasury note is 7 percent.

Basic Relationships:
r = RR + IP
IP = r – RR

a. If the expected real rate of interest is 3 percent, determine the inflation premium on
the Treasury bill.
IP = 6% – 3% = 3%
b. If the maturity risk premium is expected to be zero, determine the inflation premium
on the Treasury note.
IP = 7% – 3% = 4%
c. What is the expected inflation premium for the second year?
Expected inflation premium for Year 2 = 4% – 3% = 1%
12. A Treasury note with a maturity of four years carries a nominal rate of interest of 10
percent. In contrast, an 8-year Treasury bond has a yield of 8 percent.
Basic Relationships:
r = RR + IP
RR = r – IP
a. If inflation is expected to average 7 percent over the first four years, what is the Formatted: Font: Italic
expected real rate of interest? Formatted: Font: Italic
Formatted: Font: Italic
RR = 10% – 7% = 3%
b. If the inflation rate is expected to be 5 percent for the first year, calculate the
average annual rate of inflation for years two through four.
7% × 4 = 28% for 4 years
28% – 5% = 23% for Years 2, 3, and 4
23%/3 = 7.67% average annual rate for Years 2, 3, and 4
c. If the maturity risk premium is expected to be zero between the two Treasury
securities, what will be the average annual inflation rate expected over years five
through eight?
IP = r – RR
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 Chapter Eight: Interest Rates

Treasury note: IP = 10% – 3% = 7%

Treasury bond: IP = 8% – 3% = 5%
7% × 4 = 28% for first 4 years
5% × 8 = 40% for 8 years
(40% – 28%)/4 = 12%/4 = 3% average annual rate for Years 5, 6, 7, and 8
13. The interest rate on a ten-year Treasury bond is 9.25 percent. A comparable maturity
Aaa-rated corporate bond is yielding 10 percent. Another comparable maturity but
lower quality corporate bond has a yield of 14 percent which includes a liquidity
premium of 1.5 percent.
Basic Relationships:
r = RR + IP + DRP + MRP + LP
Treasury bond rate (TBR) = RR + IP
DRP = r – TBR – MRP – LP
a. Determine the default risk premium on the Aaa-rated bond.
Aaa rated bond: DRP = 10% – 9.25% – 0% – 0% = .75%
b. Determine the default risk premium on the lower quality corporate bond.
Lower quality bond: DRP = 14% – 9.25% – 0% – 1.5%.= 3.25%
14. A corporate bond has a nominal interest rate of 12 percent. This bond is not very liquid
and consequently requires a 2 percent liquidity premium. The bond is of low quality and
thus has a default risk premium of 2.5 percent. The bond has a remaining life of 25
years resulting in a maturity risk premium of 1.5 percent.
Basic Relationships:
Treasury bond rate (TBR) = RR + IP
r = TBR + DRP + MRP + LP
a. Estimate the nominal interest rate on a Treasury bond.
TBR = r – DRP – MRP – LP = 12% – 2.5% – 1.5% – 2% = 6%
b. What would be the inflation premium on the Treasury bond if investors required a
real rate of interest of 2.5 percent?
IP = TBR – RR = 6% – 2.5% = 3.5%
15. Challenge Problem Following are some selected interest rates.
Maturity or Term Rate Type of Security
1 year 4.0% Corporate loan (high quality)
1 year 5.0% Corporate loan (low quality)
1 year 3.5% Treasury bill
5 years 5.0% Treasury note
5 years 6.5% Corporate bond (high quality)
5 years 8.0% Corporate bond (low quality)
10 years 10.5% Corporate bond (low quality)
10 years 8.5% Corporate bond (high quality)
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 Chapter Eight: Interest Rates

10 years 7.0% Treasury bond

20 years 7.5% Treasury bond
20 years 9.5% Corporate bond (high quality)
20 years 12.0% Corporate bond (low quality)

a. Plot a yield curve using interest rates for government default risk-free securities.

The yield curve for government securities would be constructed using the following
securities with interest rates on the vertical axis and time to maturity on the horizontal
axis.

Maturity Rate Government Security

1 year 3.5% Treasury bill
5 years 5.0% Treasury note
10 years 7.0% Treasury bond
20 years 7.5% Treasury bond

b. Plot a yield curve using corporate debt securities with low default risk (high quality)
and a separate yield curve for low quality corporate debt securities.

The yield curves for corporate debt securities would be constructed using the
following securities with interest rates on the vertical axis and time to maturity on the
horizontal axis.

High Quality
1 year 4.0% Corporate loan (high quality)
5 years 6.5% Corporate bond (high quality)
10 years 8.5% Corporate bond (high quality)
20 years 9.5% Corporate bond (high quality)

Low Quality
1 year 5.0% Corporate loan (low quality)
5 years 8.0% Corporate bond (low quality)
10 years 10.5% Corporate bond (low quality)
20 years 12.0% Corporate bond (low quality)

c. Measure the amount of default risk premiums, assuming constant inflation rate
expectations and no maturity or liquidity risk premiums on any of the debt securities
for both high quality and low quality corporate securities based on information from
(a) and (b). Describe and discuss why differences might exist between high quality
and low quality corporate debt securities.

Corporate Treasury Default Risk

Default Risk Quality Securities - Securities = Premiums
High Quality:
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 Chapter Eight: Interest Rates

1-year maturities 4.0% 3.5% 0.5%

5-year maturities 6.5% 5.0% 1.5%
10-year maturities 8.5% 7.0% 1.5%
20-year maturities 9.5% 7.5% 2.0%

Low Quality:
1-year maturities 6.0% 3.5% 2.5%
5-year maturities 8.0% 5.0% 3.0%
10-year maturities 10.5% 7.0% 3.5%
20-year maturities 12.0% 7.5% 4.5%

Low quality corporate debt requires the offering of higher default risk premiums
(relative to high quality debt) to get investors to invest in riskier corporate debt.

d. Identify the average expected inflation rate at each maturity level in (a) if the real
rate is expected to average 2 percent per year and if there are no maturity risk
premiums expected on Treasury securities.
Inflation
Nominal Rate - Real Rate = Premium
1 year 3.5% Treasury bill 2.0% 1.5%
5 years 5.0% Treasury note 2.0% 3.0%
10 years 7.0% Treasury bond 2.0% 5.0%
20 years 7.5% Treasury bond 2.0% 5.5%

e. Using information from (d), calculate the average annual expected inflation rate over
years 2 through 5. Also calculate the average annual expected inflation rates for
years 6 through 10 and for years 11 through 20.

Inflation Total
Nominal Rate - Real Rate = Premium Inflation
1 year 3.5% Treasury bill 2.0% 1.5% 1.5%
5 years 5.0% Treasury note 2.0% 3.0% 15.0%
10 years 7.0% Treasury bond 2.0% 5.0% 50.0%
20 years 7.5% Treasury bond 2.0% 5.5% 110.0%

Average annual expected inflation rates:

2-5 years: (15.0% -1.5%)/4 = 13.5%/4 = 3.375%
6-10 years: (50% - 15%)/5 = 35%/5 = 7.0%
11-20 years: (110% - 50%)/10 = 60%/10 = 6.0%

f. Based on the information from (e), re-estimate the maturity risk premiums for high
quality and low quality corporate debt securities. Describe what seems to be
occurring over time and between differences in default risks.

8-21
 Chapter Eight: Interest Rates

Note: It is assumed that default risk premiums are constant across all maturities of
high quality corporate debt, as well as for all maturities of low quality corporate debt
(of course the level of default risk premiums would be higher for low quality debt
versus high quality debt).

Nominal Risk-free Maturity Risk

High Quality Rate Corporate Debt - Rate = Premium
1 year 4.0% Corporate loan 3.5% 0.5%
5 years 6.5% Corporate bond 5.0% 1.5%
10 years 8.5% Corporate bond 7.0% 1.5%
20 years 9.5% Corporate bond 7.5% 2.0%

Low Quality
5 years 8.0% Corporate bond 5.0% 3.0%
10 years 10.5% Corporate bond 7.0% 3.5%
20 years 12.0% Corporate bond 7.5% 4.5%

Maturity risk premiums are relatively higher, as well as increase more rapidly, for
low quality corporate debt compared to high quality corporate debt. The differences
are:

5-year maturities: 3.0% - 1.5% = 1.5%

10-year maturities: 3.5% - 1.5% = 2.0%
20-year maturities: 4.5% - 2.0% = 2.5%

This assumes that the default risk premium spread between high and low corporate
debt remains constant across maturities. Otherwise, the differences being observed in
terms of maturity risk premiums may actually reflect differences in default risk
premium spreads.

SUGGESTED QUIZ

1. Define or discuss briefly:

a. Real rate of interest
b. Liquidity premium
c. Treasury bills
d. Treasury bonds
e. Yield curve
f. Demand-pull inflation
g. Administrative inflation
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 Chapter Eight: Interest Rates

2. Briefly explain the loanable funds theory of interest rates.

3. Identify and describe the factors, in addition to supply and demand, that determine
nominal interest rates.
4. List and briefly describe the three basic theories used to describe the term structure of
interest rates (or shape of the yield curve).
5. Briefly describe how default risk premiums are estimated.

8-23
Another random document with
no related content on Scribd:
The Project Gutenberg eBook of Old English
colour prints
This ebook is for the use of anyone anywhere in the United
States and most other parts of the world at no cost and with
almost no restrictions whatsoever. You may copy it, give it away
or re-use it under the terms of the Project Gutenberg License
included with this ebook or online at www.gutenberg.org. If you
are not located in the United States, you will have to check the
laws of the country where you are located before using this
eBook.

Title: Old English colour prints

Author: Malcolm C. Salaman

Editor: Charles Holme

Release date: October 1, 2023 [eBook #71768]

Language: English

Original publication: London: Offices of 'The Studio', 1909

Credits: Fiona Holmes and the Online Distributed Proofreading

Team at http://www.pgdp.net (This file was produced
from images generously made available by The
Internet Archive.

*** START OF THE PROJECT GUTENBERG EBOOK OLD

ENGLISH COLOUR PRINTS ***
 Transcriber’s Note
Page 30—Chilaren changed to Children
It is noted that some of the plates are only showing part fractions - these have
been left as printed.
 OLD ENGLISH
COLOUR-PRINTS
TEXT BY
MALCOLM C. SALAMAN
(AUTHOR OF ‘THE OLD ENGRAVERS OF ENGLAND’)

EDITED BY
CHARLES HOLME
MCMIX
OFFICES OF ‘THE STUDIO’
LONDON, PARIS AND NEW YORK

PREFATORY NOTE.

LIST OF ILLUSTRATIONS.

OLD ENGLISH COLOUR-PRINTS.

II.

III.

NOTES ON THE ILLUSTRATIONS.

 PREFATORY NOTE.
The Editor desires to express his thanks to the following Collectors
who have kindly lent their prints for reproduction in this volume:—
Mrs. Julia Frankau, Mr. Frederick Behrens, Major E. F. Coates, M.P.,
Mr. Basil Dighton, Mr. J. H. Edwards, and Sir Spencer Ponsonby-
Fane, P.C., G.C.B. Also to Mr. Malcolm C. Salaman, who, in addition
to contributing the letterpress, has rendered valuable assistance in
the preparation of the work.
 LIST OF ILLUSTRATIONS.
Plate I. “Jane, Countess of Harrington, Lord Viscount
Petersham and the Hon. Lincoln Stanhope.”
Stipple-Engraving by F. Bartolozzi, R.A., after
Sir Joshua Reynolds, P.R.A.

” II. “Robinetta.” Stipple-Engraving by John Jones, after

Sir Joshua Reynolds, P.R.A.

” III. “Master Henry Hoare.” Stipple-Engraving by C.

Wilkin, after Sir Joshua Reynolds, P.R.A.

” IV. “The Duchess of Devonshire and Lady Georgiana

Cavendish.” Mezzotint-Engraving by Geo.
Keating, after Sir Joshua Reynolds, P.R.A.

” V. “The Mask.” Stipple-Engraving by L. Schiavonetti,

after Sir Joshua Reynolds, P.R.A.

” VI. “Bacchante” (Lady Hamilton). Stipple-Engraving by

C. Knight, after George Romney.

” VII. “Mrs. Jordan in the character of ‘The Country Girl’”

(“The Romp”). Stipple-Engraving by John
Ogborne, after George Romney.

” VIII. “Hobbinol and Ganderetta.” Stipple-Engraving by P.

W. Tomkins, after Thomas Gainsborough, R.A.

” IX. “Countess of Oxford.” Mezzotint-Engraving by S.

W. Reynolds, after J. Hoppner, R.A.
” X. “Viscountess Andover.” Stipple-Engraving by C.
Wilkin, after J. Hoppner, R.A.

” XI. “The Squire’s Door.” Stipple-Engraving by B.

Duterreau, after George Morland.

” XII. “The Farmer’s Door.” Stipple-Engraving by B.

Duterreau, after George Morland.

” XIII. “A Visit to the Boarding School.” Mezzotint-

Engraving by W. Ward, A.R.A., after George
Morland.

” XIV. “St. James’s Park.” Stipple-Engraving by F. D.

Soiron, after George Morland.

” XV. “A Tea Garden.” Stipple-Engraving by F. D. Soiron,

after George Morland.

” XVI. “The Lass of Livingstone.” Stipple-Engraving by T.

Gaugain, after George Morland.

” XVII. “Rustic Employment.” Stipple-Engraving by J. R.

Smith, after George Morland.

” XVIII. “The Soliloquy.” Stipple-Engraving by and after

William Ward, A.R.A.

” XIX. “Harriet, Lady Cockerell as a Gipsy Woman.”

Stipple-Engraving by J. S. Agar, after Richard
Cosway, R.A.

” XX. “Lady Duncannon.” Stipple-Engraving by F.

Bartolozzi, R.A., after John Downman, A.R.A.

” XXI. “Cupid bound by Nymphs.” Stipple-Engraving by

W. W. Ryland, after Angelica Kauffman, R.A.
” XXII. “Rinaldo and Armida.” Stipple-Engraving by Thos.
Burke, after Angelica Kauffman, R.A.

” XXIII. “Angelica Kauffman in the character of Design

listening to the Inspiration of Poetry.” Stipple-
Engraving by Thos. Burke, after Angelica
Kauffman, R.A.

” XXIV. “Love and Beauty” (Marchioness of Townshend).

Stipple-Engraving by Thos. Cheesman, after
Angelica Kauffman, R.A.

” XXV. “Two Bunches a Penny, Primroses” (“Cries of

London”). Stipple-Engraving by L. Schiavonetti,
after F. Wheatley, R.A.

” XXVI. “Knives, Scissors and Razors to Grind” (“Cries of

London”). Stipple-Engraving by G. Vendramini,
after F. Wheatley, R.A.

” XXVII. “Mrs. Crewe.” Stipple-Engraving by Thos. Watson,

after Daniel Gardner.

” XXVIII. “The Dance.” Stipple-Engraving by F. Bartolozzi,

R.A., after H. W. Bunbury.

” XXIX. “Morning Employments.” Stipple-Engraving by P.

W. Tomkins, after H. W. Bunbury.

” XXX. “The Farm-Yard.” Stipple-Engraving by William

Nutter, after Henry Singleton.

” XXXI. “The Vicar of the Parish receiving his Tithes.”

Stipple-Engraving by Thos. Burke, after Henry
Singleton.

” XXXII. “The English Dressing-Room.” Stipple-Engraving

 by P. W. Tomkins, after Chas. Ansell.

” XXXIII. “The French Dressing-Room.” Stipple-Engraving

by P. W. Tomkins, after Chas. Ansell.

” XXXIV. “January” (“The Months”). Stipple-Engraving by F.

Bartolozzi, R.A., after Wm. Hamilton, R.A.

” XXXV. “Virtuous Love” (from Thomson’s “Seasons”).

Stipple-Engraving by F. Bartolozzi, R.A., after
Wm. Hamilton, R.A.

” XXXVI. “The Chanters.” Stipple-Engraving by J. R. Smith,

after Rev. Matthew W. Peters, R.A.

” XXXVII. “Mdlle. Parisot.” Stipple-Engraving by C. Turner,

A.R.A., after J. J. Masquerier.

” XXXVIII. “Maria.” Stipple-Engraving by P. W. Tomkins, after

J. Russell, R.A.

” XXXIX. “Commerce.” Stipple-Engraving by M. Bovi, after J.

B. Cipriani, R.A., and F. Bartolozzi, R.A.

” XL. “The Love-Letter.” Stipple-Engraving, probably by

Thos. Cheesman.
 OLD ENGLISH COLOUR-PRINTS
“Other pictures we look at—his prints we read,” said Charles Lamb,
speaking with affectionate reverence of Hogarth. Now, after “reading”
those wonderful Progresses of the Rake and the Harlot, which had
for him all the effect of books, intellectually vivid with human interest,
let us suppose our beloved essayist looking at those “other pictures,”
Morland’s “Story of Letitia” series, in John Raphael Smith’s charming
stipple-plates, colour-printed for choice, first issued while Lamb was
hardly in his teens. Though they might not be, as in Hogarth’s prints,
“intense thinking faces,” expressive of “permanent abiding ideas” in
which he would read Letitia’s world-old story, Lamb would doubtless
look at these Morland prints with a difference. He would look at them
with an interest awakened less by their not too poignant intention of
dramatic pathos than by the charm of their simple pictorial appeal,
heightened by the dainty persuasion of colour.
There is a fascination about eighteenth-century prints which tempts
me in fancy to picture the gentle Elia stopping at every printseller’s
window that lay on his daily route to the East India House in
Leadenhall Street. How many these were might “admit a wide
solution,” since he arrived invariably late at the office; but Alderman
Boydell’s in Cheapside, where the engraving art could be seen in its
dignified variety and beauty, and Mr. Carington Bowles’s in St. Paul’s
Churchyard, with the humorous mezzotints, plain and coloured, must
have stayed him long. Then, surely among the old colour-prints
which charm us to-day there were some that would make their
contemporary appeal to Elia’s fancy, as he would linger among the
curious crowd outside the windows of Mr. J. R. Smith in King Street,
Covent Garden, or Mr. Macklin’s Poet’s Gallery in Fleet Street, Mr.
Tomkins in Bond Street, or Mr. Colnaghi—Bartolozzi’s “much-
beloved Signor Colnaghi”—in Pall Mall. Not arcadian scenes,
perhaps, with “flocks of silly sheep,” nor “boys as infant Bacchuses
or Jupiters,” nor even the beautiful ladies of rank and fashion; but the
Cries of London at Colnaghi’s must have arrided so true a Londoner,
and may we not imagine the relish with which Lamb would stop to
look at the prints of the players? The Downman Mrs. Siddons, say, or
the Miss Farren, or that most joyous of Romney prints, Mrs. Jordan
as “The Romp”, which would seem to give pictorial justification for
Lamb’s own vivid reminiscence of the actress, as his words lend
almost the breath of life to the picture. Yet these had not then come
to the dignity of “old prints,” with a mellow lure of antique tone. Their
beautiful soft paper—hand-made as a matter of course, since there
was no other—which we handle and hold up to the light with such
sensitive reverence, was not yet grown venerable from the touch of
long-vanished hands. They were as fresh as a busy industry of
engravers, printers, and paper-makers could turn them out, and of a
contemporary popularity that died early of a plethora.
What, then, is their peculiar charm for us to-day, those colour-prints
of stipple or mezzotint engravings which pervaded the later years of
the eighteenth century, and the earliest of the nineteenth? No
serious student, perhaps, would accord them a very high or
important place in the history of art. Yet a pleasant little corner of
their own they certainly merit, representing, as they do, a
characteristic contemporary phase of popular taste, and of artistic
activity, essentially English. Whatever may be thought of their
intrinsic value as works of art, there is no denying their special
appeal of pictorial prettiness and sentiment and of dainty decorative
charm. Nor, to judge from the recent records of the sale-rooms,
would this appeal seem to be of any uncertain kind. It has lately
been eloquent enough to compete with the claims of artistic works of
indisputable worth, and those collectors who have heard it for the
first time only during the last ten years or so have had to pay highly
for their belated responsiveness. Those, on the other hand, who
listened long ago to the gentle appeal of the old English colour-
prints, who listened before the market had heard it, and, loving them
for their own pretty sakes, or their old-time illustrative interest, or
their decorative accompaniment to Sheraton and Chippendale,
would pick them up in the printsellers’ shops for equitable sums that
would now be regarded as “mere songs,” can to-day look round their
walls at the rare and brilliant impressions of prints which first
charmed them twenty or thirty years ago, and smile contentedly at
the inflated prices clamorous from Christie’s. For nowadays the
decorative legacy of the eighteenth century—a legacy of dignity,
elegance, beauty, charm—seems to involve ever-increasing legacy
duties, which must be paid ungrudgingly.
A collector, whose house is permeated with the charm and beauty of
eighteenth-century arts and crafts, asked recently my advice as to
what he should next begin to collect. I suggested the original pictures
of the more accomplished and promising of our younger living
painters, a comparatively inexpensive luxury. He shook his head,
and, before the evening, a choice William Ward, exceptional in
colour, had proved irresistible. Yes, it is a curious and noteworthy
fact that the collector of old English colour-prints has rarely, if ever,
any sympathy with modern art, however fine, however beautiful. He
will frankly admit this, and, while he tells you that he loves colour,
you discover that it is only colour which has acquired the mellowing
charm of time and old associations. So your colour-print collector will
gladly buy a dainty drawing by Downman, delicately tinted on the
back, or a pastel by J. R. Smith, somewhat purple, maybe, in the
flesh-tints, while the sumptuous colouring of a Brangwyn will rouse in
him no desire for possession, a Lavery’s harmonies will stir him not
at all, and the mystic beauty of tones in any Late Moonrise that a
Clausen may paint will say to him little or nothing. But then, one may
ask, why is he content with the simple colour-schemes of these
dainty and engaging prints, when the old Japanese, and still older
Chinese, colour-prints offer wonderful and beautiful harmonies that
no English colour-printer ever dreamt of? And why, if we chance to
meet this lover of colour at the National Gallery, do we find him, not
revelling joyously in the marvellously rich, luminous tones of a
Filippino Lippi, for example, or the glorious hues of a Titian, but
quietly happy in front of, say, Morland’s Inside of a Stable, or
Reynolds’s Snake in the Grass?
Well, we have only to pass a little while in his rooms, looking at his
prints in their appropriate environment of beautiful old furniture,
giving ourselves up to the pervading old-time atmosphere, and we
shall begin to understand him and sympathise with his consistency.
And, as the spell works, we shall find ourselves growing convinced
that even a Venice set of Whistler etchings would seem decoratively
incongruous amid those particular surroundings. For it is the spell,
not of intrinsic artistic beauty, but of the eighteenth century that is
upon us. It is the spell of a graceful period, compact of charm,
elegance and sensibility, that these pretty old colour-prints, so
typically English in subject and design, cast over us as we look at
them. Thus they present themselves to us, not as so many mere
engravings printed in varied hues, but rather as so many pictorial
messages—whispered smilingly, some of them—from those years of
ever-fascinating memory, when the newly-born Royal Academy was
focussing the artistic taste and accomplishment of the English
people, and Reynolds, Gainsborough, Romney, were translating the
typical transient beauty in terms of enduring art, while the great
engravers were extending the painters’ fame, and the furniture-
makers and all the craftsmen were supporting them with a new and a
classic grace; when Johnson was talking stately, inspiring common-
sense, Goldsmith was “writing like an angel,” and Sheridan was
“catching the manners living as they rose”; when Fanny Burney was
keeping her vivid diaries, and Walpole and Mrs. Delany were—we
thank Providence—writing letters; when the doings of the players at
Drury Lane and Covent Garden, or the fashionable revellers at
Ranelagh, Vauxhall, and the Pantheon, were as momentous to “the
town” as the debates at Westminster, and a lovely duchess could
immortalise a parliamentary election with a democratic kiss. These
prints, hinting of Fielding and Richardson, Goldsmith and Sterne, tell
us that sentiment, romantic, rustic and domestic, had become as
fashionable as wit and elegance, and far more popular; while a
spreading feeling for nature, awakened by the poetry of Thomson,
Gray and Collins, and nurtured later by Cowper, Crabbe and Burns,
was forming a popular taste quite out of sympathy with the cold
academic formalism and trammelled feeling of the age of Pope.
These literary influences are important to consider for any true
appreciation of these old colour-prints, which, being a reflex in every
respect of the popular spirit and character of the period in which they
were produced, no other period could have bequeathed to us exactly
as they are. And it is especially interesting to remember this, for,
from the widespread popularity of these very prints, we may trace, in
the pictures their great vogue called for, the origin of that abiding
despot of popular English art which Whistler has, in his whimsical
way, defined as the “British Subject.”
That the evolution of the colour-print, from its beginnings in
chiaroscuro, can boast a long and fascinating history has been
proved to admiration in the romantic and informing pages of Mrs.
Frankau’s “Eighteenth-Century Colour-Prints”—a pioneer volume;
but my present purpose is to tell the story only in so far as it
concerns English art and taste.
Now, although during the seventeenth century we had in England a
number of admirable and industrious engravers, we hear of no
attempts among them to print engravings in anything but
monochrome; so that, if they heard of the colour-experiments of
Hercules Seghers, the Dutch etcher, whom Rembrandt admired, as
doubtless they did hear, considering how constant and friendly was
their intercourse with the Dutch and Flemish painters and engravers,
none apparently thought it worth while to pursue the idea. But, after
all, Seghers merely printed his etchings in one colour on a tinted
paper, which can hardly be described as real colour-printing; and, if
there had been any artistic value in the notion, would not the
enterprising Hollar have attempted some use of it? Nor were our
English line-engravers moved by any rumours they may have heard,
or specimens they may have seen, of the experiments in colour-
printing, made somewhere about 1680, by Johannes Teyler, of
Nymegen in Holland, a painter, engraver, mathematical professor
and military engineer. His were unquestionably the first true colour-
prints, being impressions taken from one plate, the engraved lines of
which were carefully painted with inks of different hues; and these
prints may be seen in the British Museum, collected in all their
numerous variety in the interesting and absolutely unique volume
which Teyler evidently, to judge from the ornately engraved title-
page, designed to publish as “Opus Typochromaticum.”
The experiment was of considerable interest, but one has only to
look at these colour-printed line-engravings, with their crude
juxtaposition of tints, to feel thankful that our English line-engravers
were not lured from their allegiance to the black and white proper to
their art. Doubtless they recognised that colour was opposed to the
very spirit of the line-engraver’s art, just as, a hundred years later,
the stipple-engravers realised that it could often enhance the charm
of their own. In the black and white of a fine engraving there is a
quality in the balancing of relative tones which in itself answers to the
need of colour, which, in fact, suggests colour to the imagination; so
the beauty and dignity of the graven line in a master’s hands must
repel any adventitious chromatic aid. A Faithorne print, for instance,
with its lines and cross-hatchings in colours is inconceivable;
although one might complacently imagine Francis Place and
Gaywood having, not inappropriately, experimented with Barlow’s
birds and beasts after the manner of those in Teyler’s book. If,
however, there were any English engravings of that period on which
Teyler’s method of colour-printing might have been tried with any
possibility of, at least, a popular success, they were surely Pierce
Tempest’s curious Cryes of the City of London, after “Old” Laroon’s
designs, which antedated by just over a hundred years the charming
Wheatley “Cries,” so familiar, so desirable, in coloured stipple. But
this was not to be, and not until the new and facile mezzotint method
had gradually over-shadowed in popularity the older and more
laborious line-engraving was the first essay in colour-printing made
in England. In the year 1719 came Jacob Christopher Le Blon with
his new invention, which he called “Printing Paintings.”
This invention was in effect a process of taking separate
impressions, one over the other, from three plates of a desired
picture, engraved in mezzotint, strengthened with line and etching,
and severally inked each with the proportion of red, yellow, or blue,
which, theorising according to Newton, Le Blon considered would go
to make, when blended, the true colour-tones of any picture
required. In fact, Le Blon practically anticipated the three-colour
process of the present day; but in 1719 all the circumstances were
against his success, bravely and indefatigably as he fought for it,
influentially as he was supported.
Jacob Christopher Le Blon was a remarkable man, whose ingenious
mind and restless, enthusiastic temperament led him through an
artistic career of much adventure and many vicissitudes. Born in
Frankfort in 1667—when Chinese artists were producing those
marvels of colour-printing lately discovered by Mr. Lawrence Binyon
in the British Museum—he studied painting and engraving for a while
with Conrad Meyer, of Zurich, and subsequently in the studio of the
famous Carlo Maratti at Rome, whither he had gone in 1696, in the
suite of Count Martinetz, the French Ambassador. His studies seem
to have been as desultory as his way of living. His friend Overbeck,
however, recognising that Le Blon had talents which might develop
with concentrated purpose, induced him in 1702 to settle down in
Amsterdam and commence miniature-painter. The pictures in little
which he did for snuff-boxes, bracelets, and rings, won him
reputation and profit; but the minute work affected his eyesight, and
instead he turned to portrait-painting in oils. Then the idea came to
him of imitating oil-paintings by the colour-printing process, based on
Newton’s theory of the three-colour composition of light, as I have
described. Experimenting with promising results on paintings of his
own, he next attempted to reproduce the pictures of the Italian
masters, from which, under Maratti’s influence, he had learnt the
secrets of colour. Without revealing his process, he showed his first
“printed paintings” to several puzzled admirers, among them Prince
Eugène of Savoy and, it is said, the famous Earl of Halifax, Newton’s
friend, who invented the National Debt and the Bank of England. But,
sanguine as Le Blon was that there was a fortune in his invention, he
could obtain for it neither a patent nor financial support, though he
tried for these at Amsterdam, the Hague, and Paris.
His opportunity came, however, when he met with Colonel Sir John
Guise. An enthusiastic connoisseur of art, a collector of pictures (he
left his collection to Christchurch College, Oxford), an heroic soldier,
with a turn for fantastic exaggeration and romancing, which moved
even Horace Walpole to protest, and call him “madder than ever,”
Guise was just the man to be interested in the personality and the
inventive schemes of Le Blon. Easily he persuaded the artist to
come to London, and, through his introduction to many influential
persons, he enlisted for Le Blon the personal interest of the King,
who granted a royal patent, and permitted his own portrait to be
done by the new process, of which this presentment of George I. is
certainly one of the most successful examples, happiest in tone-
harmony. Then, in 1721, a company was formed to work under the
patent, with an establishment known as the “Picture Office,” and Le
Blon himself to direct operations. Everything promised well, the
public credit had just been restored after the South Sea Bubble, the
shares were taken up to a substantial extent, and for a time all went
well. An interesting prospectus was issued, with a list of colour-prints
after pictures, chiefly sacred and mythological, by Maratti, Annibale
Carracci, Titian, Correggio, Vandyck, some of them being identical in
size with the original paintings, at such moderate prices as ten,
twelve, and fifteen shillings. Lord Percival, Pope’s friend, who, like
Colonel Guise, had entered practically into the scheme, was
enthusiastic about the results. Sending some of the prints, with the
bill for them, to his brother, he wrote: “Our modern painters can’t
come near it with their colours, and if they attempt a copy make us
pay as many guineas as now we pay shillings.” Certainly, if we
compare Le Blon’s Madonna after Baroccio—priced fifteen shillings
in the prospectus—for instance, with such an example of
contemporary painting as that by Sir James Thornhill and his
assistants, taken from a house in Leadenhall Street, and now at
South Kensington, we may find some justification for Lord Percival’s
enthusiasm. For colour quality there is, perhaps, little to choose
between them, but as a specimen of true colour-printing, and the first
of its kind, that Madonna is wonderful, and I question whether, in the
later years, there was any colour-printing of mezzotint to approach it
in brilliance of tone. Then, however, accuracy of harmonies was
assured by adopting Robert Laurie’s method, approved in 1776, of
printing from a single plate, warmed and lightly wiped after
application of the coloured inks.
Discouragement soon fell upon the Picture Office. In March 1722
Lord Percival wrote:—“The picture project has suffered under a great
deal of mismanagement, but yet improves much.” In spite of that
improvement, however, a meeting of shareholders was held under
the chairmanship of Colonel Guise, and Le Blon’s management was
severely questioned. The shareholders appear to have heckled him
quite in the modern manner, and he replied excitedly to every hostile
statement that it was false. But there was no getting away from