Number of US Bank Failures

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FDIC usually closes banks on Fridays

Total No. of

Year Failed banks GA portion

2007 3 1

2008 25 5

2009 140 25

2010 157 21

2011 92 23

2012 51 10

2013 so far 22 3

20 in Loans Go Uncollectable

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Assets Liabilities

Insolvent Bank

Reserves 30Loans 70Invests 90Premises 5

Deposits 200Capital -5

Assets Liabilities

Solvent Bank

Reserves 30Loans 90Invests 90Premises 5

Deposits 200Capital 15

FDIC closes bank

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Market Rate of Interest Rate• Market rate of interest performs an allocative function

by assuring (a) SSUs rate will be low enough so someone will

borrow from them (b) DSUs rate will be high enough so someone will lend

to them.

• In addition to Fed, interest rates affected by business opportunities (production opportunities, in book) in the economy.

• The lower the rate of interest, the greater the number of business ventures that should be profitable.

• “time preference for consumption”

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Sources of loanable funds• consumer savings• business savings• state/local government surpluses• federal government surpluses• central bank action that increases money supply

Uses for loanable funds• consumer credit purchases• business investment• state/local government deficits• federal government deficits

Loanable Funds

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Loanable Funds Theory

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Nominal vs. Real Rate of Interest

Nominal interest rate is the observed rate (the market rate).

Real rate of interest is nominal rate minus inflation.

Real rate of interest has historically been between about 2% and 4%.

Nominal interest rate consists of the real interest rate plus extra amount to compensate for the erosion in purchasing power caused by inflation.

Let i denote nominal rate of interest

r denote real rate of interest (i.e., rental rate)

denote expected rate of inflation.

Fisher Equations

Regular Fisher equation

ee PrPri *

Exact Fisher equation

ei r P

eP

Components of Exact Fisher Equation

The three terms see to it that lender gets compensated for:

1. rental of purchasing power2. anticipated loss of purchasing power on the

principal3. anticipated loss of purchasing power on the

interest

ee PrPri *

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Example 1

Normally, when we lend money, we do it to increase purchasing power. Let’s be precise about taking inflation into account.

We lend $100 for one year under the condition that the $100 gains 5% in purchasing power. Expected inflation is 8%. What interest rate should we charge?

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Example 2

Going to lend a company $3 billion to help it through a financial crisis at a rental rate of 10% plus compensation for 4% inflation. Boss says figure out interest rate to charge. What is difference between regular and exact?

1010/8

Realized Real Interest Rate

eP aP

• ex ante means based upon anticipated effects (i.e., what lies ahead)

• ex post means based upon analysis of past performance (i.e., what lies behind)

• ex ante, we assume r and forecast (expected)

• ex post, we know both i and (actual)

• Note difference between and

aPeP

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Other Forms of Fisher Equations

regular for ex ante use: exact for ex ante use:

regular for ex post use: exact for ex post use:

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Example 3

approx: exact:

Suppose a loan were set up with a nominal interest rate of 12%. What would be realized real rate of return if inflation turned out to be 4%?

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When Inflation Deviates From Anticipated

• Inflation greater than anticipated: benefits borrowers. Results in an unintended transfer of PP from lender to borrower.

• Inflation less than anticipated: benefits lenders. Results in an unintended transfer of PP from borrower to lender.

Suppose i is constructed with a specific anticipated rate of inflation built in.

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What is Fisher Effect?

…that embedded in nominal interest rates are inflation expectations.

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