Hi, I am reading interest rates and inflation section in the Economics volume. I have two questions and would be pleased if anyone could answer them: - The book says: “If the demand for bonds would rise, the price of bonds would rise, and the nominal interest rate would fall.” Why would nominal interest rate fall? - Again, the book says: “The real interest rate is determined in the capital market and the nominal interest rate is determined in the money market.” What does this sentence mean? What is the difference between these markets? Thanks!
I think: The nominal interst rate would fall because one would pay a premium for the bond. Real interest rate is essentially the coupon rate of the bond at par. Nominal interest rate could be looked at as coupon rate of a bond not at par. I have not gotten to economics yet, this is what I remember from fixed income in school.
Maybe Kjh read a different book than what I read? Nominal rate is what you get. Real rate is what you’re really getting after inflation takes a bite. Example: you buy a $100 bond for $100 with a 7% coupon. 7% is nominal rate. inflation is 3% so your real rate of return is 4% (7-3 = 4%)
The reason your nominal rate falls as bond prices rise is because your return is a combination of capital gains or loss PLUS interest. So if you pay more for a bond your return is smaller (as capital gains become less if you buy a bond below par or capital losses become greater if you buy a bond above par) therefore your nominal rate falls. virginCFAhooker’s explanation on real return is accurate. nominal interest rates are setin the treasury markets while in the capital markets they determine what return less inflation (real) is needed to compenstate for risk.
I guess, sort-of. The nominal rate on the bond is just the ytm of the bond. If the bond price increases the ytm decreases in this really straightforward mathematical way (like check out the formula). “The real interest rate is determined in the capital market and the nominal interest rate is determined in the money market.” is a pretty glib sentence. They mean that the real interest rate is determined by macroeconomic factors and nominal interest rates are controlled by, uh, something in the money market that is not related to macroeconomic factors.
joey, i was thinking the same thing, but wasnt sure how to put it. well said.
Thank you all for your answers. I am giving more of the surrounding text so that it makes more sense: - The first one: " To see why the nominal interest rate equals the real interest rate plus the expected inflation rate, think about the investment, saving and demand for money decisions that people make. Imagine first there is no inflation and none is expected. Investment equals saving at a real interest rate of 6 percent a year. WD Corporation is willing to pay an interest rate of 6 percent to get the funds it needs for its investment in a new park. If the nominal interest rate was 7 percent, WD would put its investment plans on hold and buy bonds. It would make an extra one percent interest by doing so. As WD and others bought bonds, the demand for bonds would increase, the price of bonds would rise, and the nominal interest rate would fall. Only when the nominal interest rate on a bond equaled the real interest rate on a new park would WD be in equilibrium. " - The second one: “Investment demand and saving supply determine the real interest rate in the market for financial capital. Investment demand and saving supply depend on the real interest rate. The demand for money and the supply of money determine the nominal interest rate in the money market. The demand for money depends on the nominal interest rate, the supply of money is determined by the Fed’s monetary policy. Because the real interest rate is determined in the capital market and the nominal interest rate is determined in the money market, it might seem that there is no connection between them. But there is a very tight connection. On the average, the nominal interest rate equals the real interest rate plus the expected inflation.” Thanks!
that’s the exact formula i posted, just rearrranged!?! See how the CFA can take something simple and easy and make it all longwinded, vague, stupid & twisted?