ch.8

What is the basic definition of Interest Rate?

• Compensation for the possibility of the borrower’s failure to pay interest and/or principal when due

• Price that equates the demand for and supply of loanable funds

• Interest rate on a risk-free debt instrument when no inflation is expected

• Interest rate on a debt instrument with no default, maturity, or liquidity risks

Which theory states that interest rates are a function of the supply of and demand for loanable funds?

• Liquidity Preference Theory

• Loanable Funds Theory

• Market Segmentation Theory

• Expectations Theory

What is the main factor affecting the supply of loanable funds?

• Major factor is the level of national income

• Average inflation rate expected over the life of the security

• Compensation for securities that cannot easily be converted to cash without major price discounts

• Amount of short-term credit available depends on lending policies of depository institutions and the Fed

What is the Risk-Free Rate of Interest?

• Interest rate on a debt instrument with no default, maturity, or liquidity risks

• Price that equates the demand for and supply of loanable funds

• Compensation for the possibility of the borrower’s failure to pay interest and/or principal when due

• Interest rate that is observed in the marketplace

What is the main determinant of Market Interest Rates?

• Interest rate that is observed in the marketplace

• Compensation for the possibility of the borrower’s failure to pay interest and/or principal when due

• Average inflation rate expected over the life of the security

• Interest rate on a risk-free debt instrument when no inflation is expected

What is the basic equation for determining Market Interest Rates?

• r = RR + IP + DRP

• DRP = r - RR - IP

• Risk-Free Rate (rf) = Real Rate (RR) + Inflation Premium (IP)

• DRP = r - RR - IP - MRP - LP

What is the main factor that determines the Volume of Savings?

• Amount of short-term credit available depends on lending policies of depository institutions and the Fed

• Refers to how lenders see the future

• Major factor is the level of national income

• Compensation for the possibility of the borrower’s failure to pay interest and/or principal when due

What is the definition of Inflation?

• Interest rate on a risk-free debt instrument when no inflation is expected

• Possible price fluctuations in fixed-rate debt instruments associated with changes in market interest rates

• Price that equates the demand for and supply of loanable funds

• Occurs when an increase in the price of goods or services is not offset by an increase in quality

What is the main cause of Cost-Push Inflation?

• The tendency of prices, aided by union-corporation contracts, to rise during economic expansion and to resist declines during recessions

• Caused by the expectation that prices will continue to rise, resulting in increased buying to avoid even higher future prices

• Occurs during economic expansions when demand for goods and services is greater than supply

• Occurs when prices are raised to cover rising production costs, such as wages

What is the main risk associated with Default Risk Premium?

• Occurs when an increase in the price of goods or services is not offset by an increase in quality

• Interest rate on a debt instrument with no default, maturity, or liquidity risks

• Possible price fluctuations in fixed-rate debt instruments associated with changes in market interest rates

• Risk that a borrower will not pay interest and/or repay the principal on a loan according to the agreed contractual terms