Question

Graphically analyze the effect of an exogeneous decrease in the interest rate on:

(a) The utility of borrowers and lenders

(b) The present wealth of borrowers and lenders

(c) The investment in real assets

Answer 1

A decline in interest rate would have a huge impact on the following:

a) As the interest rate decline the utility of borrowers will increase. It will be wiseful for borrowers to refinance their existing debt with a new debt unless there is a negative covenant. In simple words if a borrower has taken a loan at (X+2)% and now the interest rate declines to only X%. The borrower would take a fresh loan at X% and repay the earlier loan which was carrying a higher interest rate. In case of callable bonds the bonds are called by issuer when interest rate declines. There is a chance of prepayment in case of declines in interest rate.

For borrower decline in interest would result in lower interest payout. For firms with high debt this will be positive.

For lenders the utility decreases as their interest income decreases. The new loans or debt will be issued in the market with low rates. So there will be decline in interest rate.

b) The present wealth of lender will increase in case of decline in interest rate as all the coupon payments will be discounted at lower interest rate. as per time value of money. Giving out loan is an asset for the lenders. When the discount factor the market interest rate decllines the present value of coupon payments will increase.So the present value of the asset increases.

For borrowers the present wealth will decline as the borrower has to shed out more to the lender as explaines above.

c) Decline in interest rate will result in increase in investments in real assets. Decline in interest rate mean that money is available at a cheap rate.When ever the central bank of any country lowers the interest rate the liquidity spply increases resulting in more purchasing power of individuals and higher inflation. Higher purchasing power push up the prices of both real assets and financial assets in the economy. Individuals will shell out more in high purchasing power environment.