Determinants Of The Level Of Interest Rates : Interest rates and their future expected values are the important factors which effect our investment decisions.

Factors that effect the Interest Rates : However forecasting interest rates is not easy. We have to understand the factors that effect the rates and determine the level of interest rates:

The supply of funds from savers, primarily households.

The demand of funds from businesses to invest in plant and equipment.

The governments net supply and demand of funds.

The Equilibrium Real Rate of Interest Rate

Supply, demand of funds and government actions determine the level of interest rates.

The supply curve slops upward because the higher the real interest rate, the greater the supply of household savings.

The demand curve slops downward because the lower the int. rate, the more the businesses will want to make investments in capital goods.

Equilibrium is the point at which demand and supply curve intersect, point E.

Government can shift these demand and supply curves either to the right or to the left through fiscal and monetary policies.

Taxes and the Real Rate of Interest : Tax liabilities are based on nominal income and the tax rate determined by the investors tax bracket.

Risk And Risk Premiums : Risk means uncertainty about future rates of return. We can quantify that uncertainty using probability distributions.

The Historical Record : The record of past rates of return is one possible source of information about risk premiums and standard deviations. We can estimate the historical risk premium by taking an average of the past differences between the returns on an asset class and the risk-free rate.