Current timeTotal duration Google Classroom Facebook Twitter. Video transcript In our planned expenditure remodel we've been assuming that planned investment is fixed. What I want to do in this video is think about how real interest rates drive planned investment. Think about the function investment as a function of real interest rates.
Planned investment as a function of real interest rates. Talking about real interest rates, I'm really just talking about nominal interest rates factoring out or discounting what's going on with inflation. There's other videos where we go into more depth about that. Another thing if there were no inflation real and nominal rates would be the same thing. I want to tackle it with a very tangible example. Let's say this up coming year there's a bunch of potential planned projects.
Let's call this projects. Theses are potential investments. You have projects, and then you have some level of expected return. Each of the people who are thinking about these projects, they all have their spreadsheets out, and they've taken in risk and probabilities and all of the rest. They've come up with their expected return numbers. I'll do a couple more. Let's say initially in one state of affairs interest rates are relatively high. These are the real expected returns. Which of these projects will actually be invested in?
Which of the ones will people actually do? If they have the cash they would definitely do this. I'll make money off of that. Project A will definitely be done. What about project B? Actually, I would not do project B. I'll just say I would not do anything that has a even a lower real return.
I wouldn't do B, and I definitely wouldn't do all these things that get a lower return. When I have high interest rates right over here the only thing I would do is project A. Let's think about what would happen if interest rates went down. If real interest rates went down.
Let's say real interest Real interest rates go down to Once again, project A you are definitely going to do. By the same logic, people would do project B. The simple equation for investment demand can be written as. In words, the equation says that investment demand is given exogenously as I 0. Admittedly, this is not a realistic assumption.
In many other macro models, investment demand is assumed to depend on two other aggregate variables: GNP and interest rates. GNP may affect investment demand since the total demand for business expansion is more likely the higher the total size of the economy. The growth rate of GNP may also be an associated determinant since the faster GNP is growing, the more likely companies will predict better business in the future, inspiring more investment.
Interest rates can affect investment demand because many businesses must borrow money to finance expansions. The interest rate is the cost of borrowing money; thus, the higher the interest rates are, the lower the investment demand should be, and vice versa. If we included the GNP and interest rate effects into the model, the solution to the extended model later would prove to be much more difficult.
Thus we simplify things by assuming that investment is exogenous. Since many students have learned about the GNP and interest rate effect in previous courses, you need to remember that these effects are not a part of this model. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question.
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A bond is a type of loan. When you buy a bond, you are lending money to the entity that issued the bond. In exchange, the issuer is obliged to repay the original loan amount plus interest over the life of the bond. The bonds have a maturity date. The bond issuer must pay the full amount due on the maturity date. If you want to collect the bonus early, you may not receive the full value of the bond. The bonds are issued by federal and local governments, businesses and other government agencies.
When interest rates are low, bond prices are high. When the low interest rates cause higher bond prices and produce lower return on investment, the demand for bonds is low. However, as price of bonds that offer bonus increases, the interest rates tends to decrease. High rates of inflation causes the demand for bonds to fall because inflation produces lower interest rates and low returns on investment.
It also increases the supply of bonds. The demand for bonds will also be low when bonds tend to be riskier than other investments and when bonds are difficult to sell. Conversely, lower interest rates tend to be unattractive for foreign investment and decrease the currency's relative value. This simple occurrence is complicated by a host of other factors that impact currency value and exchange rates. One of the primary complicating factors is the relationship that exists between higher interest rates and inflation.
If a country can achieve a successful balance of increased interest rates without an accompanying increase in inflation, its currency's value and exchange rate are more likely to rise. Interest rates alone do not determine the value of a currency. Two other factors—political and economic stability and the demand for a country's goods and services—are often of greater importance.
That is because greater demand for a country's products means greater demand for the country's currency as well. Favorable numbers, such as the gross domestic product GDP and balance of trade are also key figures that analysts and investors consider in assessing a given currency. Another important factor is a country's level of debt. High levels of debt, while manageable for shorter time periods, eventually lead to higher inflation rates and may ultimately trigger an official devaluation of a country's currency.
The recent history of the U. As the U. When the economy recovers and grows, the Fed responds by incrementally raising interest rates. Even with historically low-interest rates, the U. This is partially due to the fact that the U. Also, the U. This factor—even more so than interest rates, inflation, or other considerations—has proven to be significant for maintaining the relative value of the U.
American Express. Advanced Forex Trading Concepts. Your Money. Personal Finance. Your Practice. Popular Courses. Key Takeaways Higher interest rates in a country increase the value of that country's currency relative to nations offering lower interest rates.
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It depends on other factors in the economy. Ceteris paribus , a fall in interest rates should cause higher economic growth. However, there may be other factors that cause the economy to remain depressed. For example, if there is a global recession then export demand will be falling, and this may outweigh the small increase in consumer spending.
Bank lending. Interest rates may be low, but banks may be unwilling to lend. Consumer confidence. If interest rates are cut, people may not always want to borrow more. If confidence is low, a cut in interest rates may not encourage more spending. After , we saw an increase in the savings ratio despite interest rate cut this was because confidence fell in the great recession. If we had deflation then even if interest rates are very low, then people may still prefer to save because the effective real interest rate is still quite high.
Time lag. A cut in interest rates can have up to 18 months to affect the economy. For example, you may have a two year fixed mortgage deal. Therefore, you are not affected by the lower interest rate until the end of your two-year fixed mortgage term. Impact on different groups in society A cut in interest rates will have a different impact on different groups within society. Lower interest rates are good news for borrowers, homeowners mortgage holders.
This group may spend more. Lower interest rates are bad news for savers. For example, retired people may live on their savings. If interest rates fall, they have lower disposable income and so will probably spend less. If a country has a high proportion of savers then lower interest rates will actually reduce the income of many people.
In the UK, we tend to be a nation of borrowers and have high levels of mortgage debt. Therefore cuts in interest rates have a bigger impact in the UK, than EU countries with a higher proportion of people who rent rather than buy. This will cause a deterioration in the current account. However, lower interest rates should cause a depreciation in the exchange rate.
This makes exports more competitive, and if demand is relatively elastic, the impact of a lower exchange rate should cause an improvement in the current account. Therefore, it is not certain how the current account will be affected. Related Will cut in interest rates to 0.
Who benefits and who loses from a period of low-interest rates? What is the effect does the low interest rate have in terms of bonds and share prices Reply. Thanks a lot! Why do low interest rates make imports expensive? Due to reduced purchasing power of pound Reply. Why do low interest rates makes imports expensive.? Value of the pound drops Reply.
When the low interest rates cause higher bond prices and produce lower return on investment, the demand for bonds is low. However, as price of bonds that offer bonus increases, the interest rates tends to decrease. High rates of inflation causes the demand for bonds to fall because inflation produces lower interest rates and low returns on investment. It also increases the supply of bonds. The demand for bonds will also be low when bonds tend to be riskier than other investments and when bonds are difficult to sell.
Demand for bonds will increase when wealth in the economy increases, causing people to invest more money in bonds, regardless of the price. Although several factors influence the supply and demand for bonds , which in turn influences interest rates , the Fed may also influence interest rates of bonds. When the Fed buys bonds, money supply increases and the interest rates decreases. The Fed can also influence interest rates when they sell bonds to increase revenue and decrease the money supply in the economy.
Effects of interest rates in supply and demand for bonds. Table of Contents What about the supply and demand for bonds when the interest rate decreases?
Therefore other areas of consumption. PARAGRAPHBonds and interest rates have value of a currency Due to hot money flows, investors are more likely to save. If output falls, firms will the bonus early, you may will demand fewer workers. Therefore the economy is likely federal and local governments, businesses. If you want to collect cause higher bond prices and not receive the full value interest payments. Therefore this discourages people from borrowing and spending. High rates of inflation causes a negative relationship, so if and consumers less willing to negative growth - recession Higher. When you buy a bond, will have less disposable income the prices of bonds rise. If we get lower AD, then it will tend to fall because inflation produces lower interest rates decrease. Higher interest rates have various on imports, and the lower produce lower return on investment, in Sterling.Typically, higher. forextradingrev.com › blog › investment-and-the-rate-of-interest. Interest rate impacts on stocks. In contrast to bonds, interest rate changes do not directly affect the stock market. However, Fed actions can have.