INTEREST RATES

Chapter 7
INTRODUCTION
 Lets considered an economy in which no money existed, and yet there
was the possibility of the existence of a market for credit.
 It also is instructive to consider a money economy in which no credit
markets exist.
 Under a credit less system, income recipients have two options.
i. They can exchange their money income for goods and services
(consume),
ii. or they can save some of their income and hold money, generalized
store of purchasing power.
INTRODUCTION
 If credit markets emerge in an economy, income recipients now have a
third option
iii. they can lend some of their savings and earn interest.
 In short, income recipients can consume and save as before, but now
they can save by lending their savings to others.
 So credit markets allow people to hold their savings in a non-money
form—credit instruments.
INTEREST AND THE INTEREST
RATE
 In a real-world economy in which money exists, interest is the
amount of funds, valued in terms of money, that lenders receive when
they extend credit; the interest rate is the ratio of interest to the
amount lent.
 For example, suppose that $ 100 is lent. and. at the end of 1 year. $ 110 must
be paid back. The loan principal then is $ 100, the interest paid is $10. and the
interest rate is 10 percent (because $ IO/ $ IOO = 0.10).
REASONS; WHY CREDIT
MARKETS ARISE?
 (1) different households have different personalities—they have
different preferences for present versus future consumption, and
 (2) businesses can make investments in plant, equipment, and/or
inventory that are profitable enough to enable them to pay back
interest
 DETERMINATION OF THE MARKET RATE OF
INTEREST
 Net savers, or net lenders, will supply funds to the credit market.
 Net borrowers will demand funds from the credit market.
THE SUPPLY OF CREDIT
The supply-of-credit schedule is positively sloped;
it rises from left to right. At higher interest rates
more households and businesses will become net
lenders. As the rate of interest increases, more
households observe a market rate of interest
that exceeds their personal trade-off between
present and future consumptions.
 DETERMINATION OF THE MARKET RATE OF
INTEREST
THE DEMAND FOR CREDIT

The economy's demand-for-credit schedule will be negatively

sloped; it falls from left to right. As the rate of interest falls,
more people prefer to become net borrowers.
As interest rate decreases, more households discover that the market rate of interest is
below their personal rate of interest. They decide to reduce their saving rate.
For businesses, lower interest rates mean that more investment projects exist for which
they can borrow funds, pay the interest, and keep some net profit. In short, as the rate
of interest falls, other things constant, the quantity demanded for credit rises.
 THE MARKET RATE OF

INTERES
The economy's supply of and demand for credit determine the
market rate of interest.
 Market rate of interest will be established
at 10%, where both curve intersect.
 Surplus ----- 12%------ the quantity of credit
exceeds the quantity demanded for credit.
 At 8% a shortage of credit exists.
 The quantity demanded for credit exceeds
the quantity supplied at that interest rate.
THE ALLOCATIVE ROLE OF
INTEREST
 Interest is the price that allocate loanable funds (credit) to consumers and to business.
 Business compete wit each other for loanable funds, an the interest rate allocates loanable
funds to different firms and therefore to the investment project of those firms.
 Those investment or capital projects whose rate of return are higher than the market rate of
interest in the credit market will e undertaken.
 In case of competitive environment, the funds will go to those firms that are the most
profitable.
NOMINAL VERSUS REAL
INTEREST RATES
 A nominal interest rate is defined as the rate of exchange between a
dollar today and a dollar at some future time.
 For example, if the market, or nominal, rate of interest is 10
percent per year, then a dollar today can be exchanged for $1.10 one
year from now.
 The real interest rate, on the other hand, is the rate of exchange between
goods and services (real things) today and goods and services at some
future date.
 In a world of no inflation or deflation, the nominal rate of interest is equal to the
real rate of interest.
 NOMINAL VERSUS REAL
INTEREST RATES
 A 10 percent annual rate of interest with no inflation guarantees a rate of exchange of
$1.00 in money terms with $1.10 in money terms a year from now, and vice versa.
 Assume that everyone anticipates a 10 percent annual rate of inflation, and leave aside
the complications of taxes.
 A nominal rate of interest of 10 percent per year will still mean that the rate of
exchange between dollars today and dollars a year from now is 1 to 1.1.
 But $1.10 in dollar terms a year from now will buy only $1.00 worth of the goods and
services that can be purchased today.
 If everyone anticipates a 10 percent annual inflation rate, then in real terms the 10
percent annual nominal rate of interest effectively means a zero real rate of interest.
 AN EQUATION RELATING REAL AND
NOMINAL INTEREST RATES
 The relationship between the nominal rate of interest and the real rate of interest
can be shown as an equation, given by

 This equation is used only in hyperinflation; but mostly we ignore the equation of
parentheses (),
 AN EQUATION RELATING REAL AND
NOMINAL INTEREST RATES
 The equation for the nominal interest rate is

 This equation can be rearranged to show that

 THE DEMAND FOR AND SUPPLY OF CREDIT, OR
LOANABLE FUNDS, REVISITED
 It was originally drawn under the implicit
assumption that there were no inflationary
expectations at 10%.
 Now assume that demanders have
Inflationary expectations of 10 percent per
year. The demand curve will shift upward
by that amount to D' .
Assume further that the suppliers of credit have the same expectations. The supply
curve will also shift up by 10 percent to S‘.
The new nominal interest rate will rise by about 1 percentage points, from 1
percent to 20 percent.
 DIFFERENT TYPES OF NOMINAL INTEREST
RATES
 Every lending market has its own interest rate.
 There is a mortgage market, a short-term business loan market, and a
government securities market.
 For every type of market lending instrument—such as a government bond
or a mortgage—there is a particular interest rate .
 Some of the most important interest rates are discussed here.
i. The Prime Rate
ii. The Corporate Bond Rate
iii. The Federal Funds Rate
 THE PRIME RATE
 The prime rate is the interest rate that commercial banks charge
creditworthy customers and is based on the Federal Reserve's federal
funds overnight rate.
 This is the rate that banks charge on short-term loans made to large corporations
with impeccable financial credentials—their "most creditworthy customers," as the
newspapers refer to them.
 The published prime rate is typically the lowest interest rate that such creditworthy
businesses pay for short-term loans.
THE CORPORATE BOND RATE
 Another important interest rate is the one paid on high-grade (low-risk)
corporate bonds.
 That annual interest payment, divided by the price of the bond, is
the corporate bond rate.
 Different corporations borrow at different bond rates, depending on
the financial soundness (creditworthiness) of the institution backing
the rate.
 THE FEDERAL FUNDS RATE
 The federal funds rate is the rate at which depository institutions borrow
and lend reserves in the federal funds market, the market for interbank
lending .
 In fact, there is no single "federal funds rate": the federal funds
rate reported daily in the Wall Street Journal and other news sources really
is an average of rates across institutions.
PAKISTAN RATE OF INTEREST
(2023)
Related Last Previous Unit Reference
Interest Rate 22.00 21.00 percent Jun 2023

Interbank Rate 21.92 21.94 percent Jun 2023

Money Supply M1 25016844.00 24802264.00 PKR Million May 2023

Money Supply M0 10915151.00 11256363.00 PKR Million May 2023

Money Supply M2 29858755.00 29433282.00 PKR Million May 2023

Money Supply M3 33140223.00 32743306.00 PKR Million May 2023

Loans to Private Sector 6922570.00 7121322.00 PKR Million May 2023

Foreign Exchange Reserves 8527.70 9456.90 USD Million May 2023

PART 2
 THE CALCULATION OF
INTEREST YIELDS
 NOMINAL YIELD
If a bond is issued for $1,000 with an agreement to pay, say. $100 in interest every
year, then it has an annual coupon rate of interest of 10 percent.
 This is also called its nominal yield ("yield" is synonymous with interest rate).
 The nominal yield is defined as
Where rn = nominal yield
C = annual coupon interest payment
F = face amount of the bond
 THE CALCULATION OF
INTEREST YIELDS
 There are two other measures of return to a bond—its current yield and its yield to
maturity (or effective yield).

 1. CURRENT YIELD
Current yield is the dollar annual interest expressed as a percentage of the current
market price of the bond. i.e
where r, stands for the current yield and P stands for the price of the bond
 Bonds are often issued (and resold) at a price different from their face
value.
 Thus, a 6 percent bond currently selling at $900 would have a nominal yield of 6
percent ($60 divided by $1,000) but a current yield of 6.67 percent ($60 divided by
$900).
 THE CALCULATION OF
INTEREST YIELDS
 2. YIELD TO MATURITY (OR EFFECTIVE YIELD)
The yield to maturity on a long-term bond is more difficult to calculate.
 The difficulty stems from the fact that such bonds typically are sold at a discount—at a
price less than their face value—and are redeemed at maturity for their face value.
 For example, consider a 3-year bond that has a face value of $1,000. pays $50 per year
in coupon interest, and is currently selling for $875.65. What is the effective yield on
that 3-year bond?

 Discounted Present Value

discounted present value, or the value today of dollars in the future.
 THE CALCULATION OF INTEREST YIELDS
 Discounted Present Value
If there are only two periods and the relevant interest rate is the rate of return from
saving, rs then there is a direct relationship between a future value of a good, a service,
or an amount of funds and the value as perceived in the present.
Q1 = [1/(1 + rs )] Q2
 where Q2 is the value of a good, a service, or an amount of funds in the second period
and Q1 is the present value of that future amount Q2.
 Because the present value of future funds in a two-period setting depends on a rate of
interest, it should come as no surprise that computing discounted present value across
several time periods also is intimately related to the interest rate
 THE CALCULATION OF INTEREST YIELDS
 Discounted Present Value
The value today of any amount of funds in the future is given by the equation

 where P - discounted present value—the value today, or the market price of the asset
(today's market price of an asset will reflect the asset's present value)
R1 = the amount of funds to be received 1 year hence
R2 = the amount of funds to be received 2 years hence
R3 = the amount of funds to be received 3 years hence
Rn = the amount of funds to be received n years hence
r = the market rate of interest
 THE CALCULATION OF INTEREST YIELDS
 Discounted Present Value

 Example:
Suppose that a bond with a face value of $ I000 pays $ 50per annum and matures in 3
years. If the market rate of interest is 10 percent, what will be the selling price of that bond
today?
According to our equation (remembering that in the third year the bond owner receives
$50 coupon interest.
Because the discounted present value of that
bond is $875.65. a competitive market will price
that bond precisely at its economic value.
 THE CALCULATION OF INTEREST YIELDS
 Yield to Maturity and Discounting
We are now ready to return to our original question. What is the yield to maturity of a 3-
year bond that has a face value of $1,000, pays S50 per annum in coupon interest (has a
nominal yield of 5 percent), and is currently selling for $875.65?
 We can use equation
to help us calculate the yield to maturity of this bond. Note that P = $875.65.
R1 = R2 = $50, R3= $1,050, and r is the unknown.
Thus,

Solving for r will give r = rm = 0.10 (10 percent)

 TREASURY BILL RATES
 A Treasury bill (T-Bill) is a short-term U.S. government debt obligation backed by the
Treasury Department with a maturity of one year or less.
 Treasury bills are issued when the government needs money for a short period. These
bills are issued only by the central government, and the interest on them is determined
by market forces.
 Published Treasury bill rates are discount rates based on a 360-day year. (The 360-day
year is used for ease of calculation.)
 The T-bill rate is calculated from the following equation:
where rB = the T-bill rate
F = the face value of the T-bill
P = the price paid for the T-bill
n = the number of days to maturity
 TREASURY BILL RATES
 Consider the following example: A $10,000, 91-day T-bill is sold at auction
for $9,685.

 The Treasury would therefore list the T-bill rate for this auction at 12.462
percent.
 TREASURY BILL RATES
 Calculating a Treasury Bill Equivalent Coupon Yield
Published Treasury bill rates are based on a 360-day year and the face value
of the investment.
 Coupon yield equivalents are based on a 365-day year and the market price
of the bill.
 To obtain a coupon yield equivalent, or an approximation to the true annual
yield, substitute a 365-day year and the actual purchase price of the T-bill at
the beginning of the period in T-bill equation.
 TREASURY BILL RATES
 Here ry equals the approximate coupon yield.

 P equals the price paid for the T-bill and n is the number of days to maturity.
 The term (F - P)/P gives the interest rate per period, and 365/n, gives the number of periods per year.

 Using the previous example for a 91 -day. $10,000 T-bill sold at auction for $9,685, the simplified
formula becomes
ry = [(100 - 96.850)/96.850) X (365/91) = 0.13046
 The coupon yield on this T-bill is 13.046 percent. It is higher than the published T-bill rate because it
takes into account:
 (1) the actual number of days in a year and
 (2) the fact that the interest is earned on the price paid for the T-bill rather than its face value.