Forecasting Interest Rates

Structural Models
 Structural Models
 Structural models are an attempt to
determine causal relationships between
various economic variables:
 Exogenous variables: Taken as given
 Endogenous Variables: Explained by the model

Exogenous Model Endogenous

 Example: Demand
 Demand:
 Exogenous:Income (I), Price (P)
 Endogenous: Quantity Demanded (D)

Exogenous Endogenous
Income Model Quantity
Price Demanded
D = D( I, P)
 Example: Demand
 The basic model
28
suggests that as
prices fall, quantity 24

demanded rises 20

Price ($)
16
 For a given level of
income and 12
preferences, if P=$12, 8
Q = 300. 4
 If price falls to $8 0
(again, for a fixed level 0 100 200 300 400 500
of income and Quantity
preferences), Q =400
 Example: Demand
 As income increases,
32
demand increases. 28
 For a given level of 24
income and 20

Price ($)
preferences, if P=$12, 16
Q = 300. 12
8
 If Income rises, Q=400
4
at a price of $12
0
0 100 200 300 400 500
Quantity
 Example: Supply
 Supply:
 Exogenous: Costs (C), Price (P)
 Endogenous: Quantity Supplied (S)

S = S(C, P)
 Example: Supply
 The basic model
24
suggests that as
20
prices rise, quantity
16
supplied increases

Price ($)
12

0
0 100 200 300 400 500
Quantity
 Example: Supply
 As costs rise, supply
28
falls 24
 Qs = S(C,P) 20

Price ($)
16
12
8
4
0
0 100 200 300 400 500
Quantity
 Equilibrium
 Qd = D(I,P) 28
 Qs = S(C,P) 24
 In Equilibrium, Qs = Qd 20

Price($)
16
12
 P* = P(I,C) 8
 Q* = Q(I,C) 4
 Note that Price is no 0
0 100 200 300 400 500
longer exogenous, it is
Quantity
explained!
 Using Models to Forecast
 In the previous example, we ended up with a
price equation
P = P(C,I)
 The next step would be to estimate the model
P = a(C) + b(I) (where a and b are constants)
 Now, note that the following implies:
 P’ = a(C’) + b(I’) (‘ indicates a future value)
 Therefore, to forecast Price:
 Forecast Costs (C’)
 Forecast Income (I’)
 Insert into the estimated price equation to get P’
 Interest Rate Models
(Real Interest Rates)
 Economic models look at how optimizing
behavior by households and firms
translates into the supply and demand for
credit.
 Firms choose capital investment projects to
maximize shareholder value (Demand)
 Households choose consumption/savings to
maximize utility (Supply)
 Supply = Demand defines the equilibrium
interest rate
 Household Savings

 Without an active financial markets,

household consumption is restricted to
equal current income
 With capital markets, the present value of
lifetime consumption must equal the
present value of lifetime income (assuming
all debts are eventually repaid)
 A Simple Example
 Suppose that your current income is equal to
$50,000 and you anticipate next year’s income
to be $60,000. The current interest rate is 5%.
 In the absence of financial markets, your
consumption stream would be $50,000 this year
and $60,000 next year.

C = Y (Current Consumption = Current Income)

C’ = Y’ (Future Consumption = Future Income)
 Consumption Possibilities

100
90
Future Consumption (000s)

80
70
60
50
40
30
20
10
0
0 10 20 30 40 50 60 70 80 90 100
Current Consumption (000s)
 Now, Add Financial Markets
 You can alter your current consumption by taking out a
loan or putting money in the bank

Y (Current Income)
C = $50,000 + (Borrowing/Lending)

 Loans must be repaid with interest next year. Deposits

earn interest (for simplicity assume that these rates are
the same)

C’= $60,000 – (1.05)(Borrowing/Lending)

Y’ (Future Income)
 Now, Add Financial Markets
 We can combine these two conditions to get the
following:

C' Y'
C Y 
(1  r ) (1  r )

In the previous example, we had

C' $60,000
C  $50,000 
(1.05) (1.05)
 Consumption Possibilities
Lending
120
Futuer Consumption (000s)

100
80
60 Borrowing
40
20
0
0 10 20 30 40 50 60 70 80 90 100 110 120

Current Consumption (000s)

The budget constraint indicates all the possible ways to

consume your lifetime wealth (PV of lifetime income)
 Consumption Possibilities

120
F u tu e r Co n su m p tio n (0 0 0 s)

100
80
60 $112,500
40
20 $107,142
0
0 10 20 30 40 50 60 70 80 90 100 110 120

Current Consumption (000s)

Slope = $112,500/$107,142 = 1.05 = (1+ r)

This is the relative price of future consumption in

terms of current consumption
 Optimal Behavior
 Households need a way to “Rank”
consumption/savings choices. This is done with
a Utility Function

U(C, C’) = Total Utility

 Utility functions only have two restrictions

 More of everything always better (total utility is
increasing in consumption)
 The more you have, the less its worth (As
consumption increases, marginal utility decreases)
 Optimal Behavior
 Given the possibilities, households choose an optimal
solution

Marginal Benefit = Marginal Cost

Increase in Decrease in
Happiness From Happiness From
Spending an = Spending an (1+r)
Extra $ Today Extra $ Tomorrow
(Marginal Utility) (Marginal Utility)
 Optimal Consumption
120

100

80

60

40

20

0
0 10 20 30 40 50 60 70 80 90 100 110 120

Savings = $20,000

Suppose that at an interest rate of 5%, you choose to save $20,000. Note that
tomorrow’s consumption is now $60,000 + $20,000(1.05) = $81,000
 Savings

9
8
7
Interest Rate (%)

6
5
4
3
2
1
0
0 10 20 30 40 50
Savings ($)
 Optimal Behavior
 We know this decision is optimal.
Therefore, we can say that:

Marginal Utility Marginal Utility

= (1.05)
At C = $30,000 At C’ = $81,000
 Optimal Behavior
 Suppose that interest rates increase to
7%.

Marginal Utility Marginal Utility

< (1.07)
At C = $30,000 At C’ = $81,000

We need to alter consumption a bit to re-balance this

equation!! (We need to raise today’s marginal utility and
lower tomorrow’s!!)
This can be done by raising future consumption and
lowering current consumption.
 Optimal Consumption
120

100

80

60

40

20

0
0 10 20 30 40 50 60 70 80 90 100 110 120

Savings = $30,000

Suppose that at an interest rate of 7%, you choose to save $30,000. Note that
tomorrow’s consumption is now $60,000 + $30,000(1.07) = $92,100
 Aggregate Savings

10
9 S
8
Interest Rate (%)

7
6
5
4
3
2
1
0
0 10 20 30 40 50
Savings ($)
 Optimal Behavior
 Suppose you alter your consumption to
C = $20,000 (S = $30,000) , C’ = $92,000

Marginal Utility Marginal Utility

= (1.07)
At C = $20,000 At C’ = $92,100

The new consumption pattern is also optimal!!

 Again, assume that the interest rate is 5%,
consider two individuals

Person A Person B
Current income: Current Income:
$10,000 $50,000
Anticipated future Anticipated Future
income: $50,000 income: $8,000
Wealth: $57,619 Wealth: $57,619
 Consumption and Wealth
70
60 0

50 10
40
30
20
10 50
0 57.6
0 10 20 30 40 50 60 70
 Consumption and Wealth

 With capital markets, consumption is not

determined by current income, but by wealth
(present value of lifetime income)
 These two individuals, having the same wealth,
should choose the same consumption
 Again, assume that the interest rate is 5%,
consider two individuals

Person A Person B
Current income: $10,000 Current Income: $50,000
Anticipated future Anticipated Future
income: $50,000 income: $8,000
Wealth: $57,619 Wealth: $57,619
Current Spending: Current Spending:
$30,000 $30,000
Savings: -$20,000 Savings: $20,000
 Consumption and Wealth
70
60 0

50 10
40
30
20
10 50
0 57.6
0 10 20 30 40 50 60 70

S = -$20,000 S = $20,000
(Person A) (Person B)
 Consumption and Wealth

 With capital markets, consumption is not

determined by current income, but by wealth
(present value of lifetime income)
 These two individuals, having the same wealth,
should choose the same consumption.
 For a given level of wealth, savings declines with
income growth
 Aggregate Savings

10
9 S’ S
8
Interest Rate (%)

7
6
5
4
3
2
1
0
0 10 20 30 40 50
Savings ($)
From the previous example, a rise in income growth might reduce
savings from 20 to 10.
A Quantitative Example

1
c c2 
1

Max 
1
 
c1 ,c2  1- 1 
s.t. c1  S  Y1
c2  (1  r ) S  Y2
 Step #1: Affordability
c1  S  Y1
c2  (1  r ) S  Y2
Recall that the two constraints can be reduced to
one constraint by eliminating ‘S’

c2 Y2
c1   Y1 
1  r  1  r 
 Step #2: Optimality
c c2 
11
U  c1 , c2    
1

 1 -  1   
Increase in Decrease in
Happiness From Happiness From
Spending an = Spending an (1+r)
Extra $ Today Extra $ Tomorrow
(Marginal Utility) (Marginal Utility)
 Step #2: Optimality
c c2 
1
1
U  c1 , c2     1

 1 -  1   
Marginal Utilities are just the derivatives!!

( c )  (  c )1  r 

1

2

Marginal Utility Today Marginal Utility Tomorrow

 Characterizing the Solution

 1  c2 
(1  r )    
   c1 
 Note that the interest rate is independent of the absolute level
of consumption. (The interest rate is stationary)
 The long run mean is determined (primarily) by beta
 The Variance is determined by sigma
 Current and Future consumption can be found by inserting the
above restriction into the wealth constraint
 US Interest Rates
 In the US, real consumption growth averages 2.5% per year
 Beta is assumed to equal .98, sigma equals 1

 1 
1.025  4.6%
1
(1  r )  
 .98 
Suppose that US consumption growth increases to
3.5%........

 1 
1.035  5.6%
1
(1  r )  
 .98 
 Capital Investment
 Investment refers to the purchase of new
capital equipment by the private sector
 Firms only invest in projects that add to
shareholder value. Therefore, they invest in
positive net present value projects.

Present Value of Lifetime Profits > Cost

 A Numerical Example
 Consider an investment project that generates $25/year in
profits. It has an initial cost of $100. The current interest
rate is 5%. Is this project worthwhile?

Present $25
$25 + (1.05) +
$25 $25 ...
= 2 + 3 +
Value (1.05) (1.05)

Year 0 Year 1 Year 2 Year 3

Present $25
Value = .05 = $500 > $100

Cost
 A Numerical Example
 An alternative way of asking the same question
is: Does this project generate a sufficient internal
rate of return given the firm’s cost of capital
(5%)?
Annual $ Return
Internal $25
Rate of = = .25 > .05
Return $100

Investment Cost

Given the 5% market interest rate, any project that generates

an internal rate of return of at least 5% is profitable
 Defining Production
 A production function defines total output for
given supplies of the factors of production
(Capital, Labor and Productivity)

Y = F(K, L, A)

Output Capital Productivity

Labor

Production should exhibit diminishing marginal returns.

That is, as capital increases (holding other factors fixed),
its contribution to production decreases
 Production (Holding Employment
Fixed)
90
80 F(K,L,A)
70 Internal Rate of
60 $10
Profits ($)/Yr

Return = 10%
50
40 $100
30
20 Internal Rate of
10 $25
Return = 25%
0
0 200 400 600 800 1000
$100 Capital ($)
 Internal Rates of Return

30

25
Return (%)

20

15

10

0
0 200 400 600 800 1000
Capital ($)

Given the market interest rate of 5%, the first 5 investment

projects are profitable.
 Investment Demand
 It is assumed that labor and capital are
compliments. That is, when employment rises,
the productivity of capital increases as well.
 Therefore, as a rise in employment should
increase the demand for capital and, hence, the
demand for loans
 Further, any technological improvement should
also raise the demand for investment
 A Rise in Investment Demand
35
30

25
20
15
10

5
0
0 200 400 600 800 1000

At a market interest rate of 10%, a productivity improvement

might increase investment demand from $400 to %500
A Numerical
Example This is the Production
Function

 1 
 

Max    Akt  L1  Pk I t
t  0  1  rt 
It

subject to kt 1  kt  I t
This is the
New investment Cost of
increases the capital Investment
stock

To get the internal rate of return, take the derivative of

production with respect to ‘K’ and divide by the price of
capital.
 Characterizing the Solution

 1
 A  k 
r    
 Pk  L 
From the Demand side, we see that the interest
rate is influenced by:
•Productivity (A)
•Price of Capital (P)
•Relative Factor Supplies (K, L)
 Capital Market Equilibrium
 A capital market 20
equilibrium is an interest
rate that clears the 16
market (i.e.,savings S

Interest Rate
equals investment) 12
 r*= 10%,
 S* = I*= 300
8
I
4

0
0 100 200 300 400 500
 Example: Oil Price Shocks

 Two oil price shocks occurred in the 1970’s. The first

(1973) was widely considered permanent while the
second (1979) was considered more temporary
 First Oil Price Shock
A rise in energy prices
20
permanently lowers
incomes 16
S

Interest Rate

 1  c2  12
(1  r )    
   c1  8
I
4
With both current and
future consumption
0
falling, savings does 0 100 200 300 400 500
not change
 First Oil Price Shock
A rise in energy prices
20
permanently lowers
productivity 16
S
 1

Interest Rate
 A  k  12
r    
 Pk  L  8
I
4
A drop in productivity
lowers investment
0
demand 0 100 200 300 400 500

Interest rates should fall

 Second Oil Price Shock
A temporary rise in oil
20
prices temporarily lowers
income and consumption 16
(c1 falls) S

Interest Rate
 12
 1  c2 
(1  r )     8
   c1  I
4
To “buffer” some of
the loss in income, 0
savings drops 0 100 200 300 400 500
 Second Oil Price Shock
A temporary drop in
20
productivity has a
negligible impact on 16
capital investment S

Interest Rate
projects 12

 1
 A  k  8
r     I
 Pk  L  4

0
Investment remains 0 100 200 300 400 500
unchanged

Interest rates rise

 Example: Oil Price Shocks
20

15

10
Inflation
5 Real
Nominal
0
1/1/1965

1/1/1968

1/1/1971

1/1/1977

1/1/1980

1/1/1983

1/1/1995

1/1/1998
1/1/1974

1/1/1986

1/1/1989

1/1/1992

1/1/2001
-5

-10

 Real interest rates fell in (1973), but increased

in 1979.
 Government Deficits and Interest
Rates
 Last year, the government borrowed
roughly $450 billion from financial markets.
Should this have an impact on real
interest rates?
 Nominal Interest Rates & Inflation
 i = r + Inflation?
 Wealth effects (Higher inflation lowers the
purchasing power of lifetime wealth)
 The Darby effect (The government taxes
nominal income)
 Expected vs. Actual inflation
 Nominal Interest Rates & the Fed
 The Federal Reserve has two potentially
offsetting effects on the nominal interest
rate:
 LiquidityEffect
 Anticipated Inflation effect
Forecasting Nominal Interest Rate
 Any Interest rate equation could potentially
have any of the following variables:
 Income Growth
 Proxies for productivity
 Relative price of capital
 Government Deficits
 Inflation Rates
 Monetary Policy Variables
 Mehra Model
it  .22 .71  t   .61 RFRt   .12  ln yt   .34 RFRt 1 
 .37(it 1 )  .37  t 1   .23 it 1   .07 it  2 
 .04 it 3   .15 it  4 

 If you are currently in time ‘t’ and would like to

make a forecast of TBill rates in time ‘t+1’. What
would you need?
 Mehra Model
 To Forecast the TBill rate, you need:
 A Forecast for price (to calculate the inflation
rate)
 A Forecast of Federal Reserve Policy
 A Forecast of GDP (to calculate income
growth)
 Past history of TBill Rates and Inflation