Econ 423 Michael SalemiInterest Rates in the Short RunClass Notes1. Reviewa. What does Fisher mean when he says that the real rate of interest is, in the long run,determined by the interaction of the patience of the population and the productivity ofcapital?b. What sort of exogenous change (shock) would raise the long run rate of interest?c. What sort of shock would lower the long run rate of interest?2. In the short run, the nominal rate of interest is determined by the demand for and supply ofloanable funds.a. The supply of loanable funds is saving by households, firms, the components ofgovernment that are running surpluses.b. The demand for loanable funds is investment demand by firms, demand for consumerdurable goods and housing by households, and borrowing by the components ofgovernment that are running deficits.c. The rest of the world is a source of funds ( saving ) when the United States is running acurrent account deficit. The rest of the world is a use of funds (investment) when theUnited States is running a current account surplus.3. There are several important reasons why the short run rate of interest can be different from thelong run rate of interest.a. In the long run, the government budget is balanced. In the short run, it may be in deficitor surplus.b. In the long run, the nation’s current account is balanced. In the short run, it may be indeficit or surplus.c. In the long run, the inflation rate is constant and inflation expectations are correct. In theshort run, the inflation rate and inflation expectations may be changing. In the short run,inflation expectations may not be correct.4. Discussion Questionsa. How, according to the demand and supply model, do the following shocks change theequilibrium rate of interest?i. An increase in consumer confidence.ii. An decrease in capital capacity utilization.iii. An increase in the S&P 500 stock price index.iv. A decrease in the value of the US dollar vis a vis the Euro.v. An increase in the federal funds rate.b. What is the relative importance of the various sources of saving in the US today?Savings Equals InvestmentFor the economy as a whole, investment is identically equal to saving. The identity follows from theGDP identity (Y = C + I + G + X-M). Let subscript H designate the household sector, subscript B the business sector, subscript G thegovernment sector and subscript F the foreign sector.We use two common decompositions of GDP:Y = C + IH + IB + G + X-M Y = Wages + Profits + Rents + Interest PaymentsThe first decomposition accounts for GDP according to how it is spent or absorbed. The second accountsfor how GDP is earned by various productive factors.The first step is showing that S = I is to obtain expressions for the saving flows of each sector of theeconomy. In the following TNTj is Taxes net of Transfer Payments in sector j.H: SH = [Wages + Rents + Interest + Dividends] - TNTH - CB: SB = Profits - TNTB - DividendsG: SG = TNTH + TNTB - GF: SF = IM - EXTotal Saving is the sum of the sector saving componentsS = SH + SB + SG + SF = [Wages + Rents + Interest + Dividends - TNTH - C] + [Profits - TNTB - Dividends] + [TNTH + TNTB - G] + [M -X] = Wages + Rents + Interest + Profits - C - G - (X-M) = IH + IBTherefore, the sum of saving across sectors of the economy is identically equal to total investment in thehousehold and business sector.Questions:1. What is the intuition for considering M-X as part of saving?2. How have the components of US saving changed in the last twenty years? Short Run Determination of the Rate of InterestIn the short run, the rate of interest is determined by equilibrium in the loanable funds market.The demand for funds is the demand for funds to finance new investment projects, consumerdurable purchases, construction of new housing, and government budget deficits.The supply of funds is household saving, firm saving, surpluses by components of thegovernment (states and localities). Supply of Funds Demand for Funds R An increase in desired investment spending, an increase in government budget deficits, an increase inhousehold demand for funds for durable purchases, all cause an increase in the demand for loanable fundsand, other factors unchanged, an increase in the nominal interest rate. S D0 R D1 An increase in household or firm saving, an increase in government budget surplus, or an increase in thecurrent account deficit adds to the supply of loanable funds.S0 D R S1 An increase in the expected rate of inflation, ceteris paribus, causes an increase in the demand for fundsand a decrease in the supply of funds. The vertical size of the shift in demand and supply is exactly equalto the change in the expected rate of inflation. S1D0R S0D1 .05 .06 An Alternative Approach: Demand for and Supply of Bonds1. Mishkin explains that the demand and supply for loanable funds can be recast as the demand andsupply for the financial asset (bond) issued by the agent who desires to borrow. a. The agent who demands loanable funds supplies bonds.b. The agent who supplies loanable funds demands bonds.c. Demand and supply jointly determine the equilibrium price of the bond.d. The equilibrium interest rate is the yield to maturity of the bond which is inverselyrelated to its price.2. The “bond” that is presumed to underlie the loanable funds approach can be taken to be one yearcommercial paper, a discount bond issued by borrowers who have good credit ratings.a. One advantage of the “bond” approach is that it allows us more easily to understand howchanges in the yield to maturity of one asset affect the yields to maturities of others.b. Savers consider different bonds to be substitutes. If the yield on one rises, they are likelyto sell the lower-yield bonds in order to buy the higher yield bond.3. We will not cover the “liquidity preference” approach to the determination of interest rates.In the short run, the government budget may be in surplus or in deficit.Federal Govt Saving as Share of GDP -0.080-0.060-0.040-0.0200.0000.0200.0400.060Jan-47Jan-51Jan-55Jan-59Jan-63Jan-67Jan-71Jan-75Jan-79Jan-83Jan-87Jan-91Jan-95Jan-99Jan-03In the short run, the government current account may be in surplus or in deficit.Current Account as Share of