Financial Markets and Interest Rates

* Federal funds rate – the rate paid on overnight loans made from one US bank to another.  It is a sensitive rate and indicative of the amount of liquidity in the economy.

* Three features of a bond that determine the interest rate:

1. The maturity of the loan

2. The likelihood of default

3. The tax status on the loan’s interest income

* Treasury bills mature in less than one year and pay no coupon payments

* Treasury notes mature between one and ten years and make coupon payments

* Treasury bonds mature in more than ten years and make coupon payments

* Municipal bonds are long-term debt obligations of local governments.  Generally not subject to income tax.

* Commercial paper – short term (< 1 year) bonds issued by large firms

* Corporate bonds – long term bonds issued by large firms

* Mortgages – bonds to finance construction of new buildings

     · Fixed rate – monthly payments do not vary

     · Adjustable rate – monthly payments fluctuate based on the interest rates on short-term government bonds

* Term structure of interest rates

      – the relationship between interest rates on bonds with similar characteristics and the maturity of those bonds.Primary markets

      – markets for the exchange of new issues of financial instrumentsSecondary markets

      – markets for previously issued bonds & stocks.  

i = (R - Pb) / Pb

i = interest rate

R = prinriple of the bond, to be paid at maturity

Pb = the price of the bond today

Thus, increases in the interest rate reduce the current price of the bond.

* Types of unemployment:

     · Cyclical unemployment – due to a deficiency of aggregate demand

     · Frictional unemployment – due to imperfect information, job search, frictions in the economy

     · Structural unemployment –due to structural changes in the economy, workers no longer fit (e.g. blacksmiths in today’s world of automobiles)

* Natural rate of unemployment – even in a booming economy, there is always a certain % of people looking for a job.  When the economy is at or below the natural rate of unemployment, an increase in demand will result in higher prices (for the US, this is about 5%).  In the 1990s, unemployment got down to 4% but no inflation.  This was because of increased productivity and outsourced labor (see the “To Boldly Go” article.

* Index of leading indicators:

· Yield curve

· Durable backorders

· Consumer sentiment – from the U. of Michigan survey:

            o Consumer durables can be predicted fairly well from consumer sentiment

            o Captures a lot of what is going on in the economy.Interest rates:

· Money rates – short term rates; near rate

· Prime rate – rate banks give their best customers

· Discount rate – rate the Fed charges member banks; only rate the Fed actually sets

· Federal funds rate – interest rates for overnight bank-to-bank loansWhat determines interest rates:

· Term to maturity of loan

· Probability of and conditions for default

       o Pledge collateral

       o Quality of assets· Tax status

· Tax status