166 Part 3 Financial Assets
environment, money is transferred from Market H to Market L and the risk pre-
mium rises from 2% to 8%! 4% " 4%.
There are many capital markets in the United States, and Figure 6-1 highlights
the fact that they are interconnected. U.S.! rms also invest and raise capital
throughout the world, and foreigners both borrow and lend in the United States.
There are markets for home loans; farm loans; business loans; federal, state, and
local government loans; and consumer loans. Within each category, there are re-
gional markets as well as different types of submarkets. For example, in real estate,
there are separate markets for! rst and second mortgages and for loans on single-
family homes, apartments, of! ce buildings, shopping centers, and vacant land.
And, of course, there are separate markets for prime and subprime mortgage loans.
Within the business sector, there are dozens of types of debt securities and there
are several different markets for common stocks.
There is a price for each type of capital, and these prices change over time as
supply and demand conditions change. Figure 6-2 shows how long- and short-
term interest rates to business borrowers have varied since the early 1970s. Notice
that short-term interest rates are especially volatile, rising rapidly during booms
and falling equally rapidly during recessions. (The shaded areas of the chart indi-
cate recessions.) When the economy is expanding,! rms need capital; and this de-
mand pushes rates up. Also, in" ationary pressures are strongest during business
booms, also exerting upward pressure on rates. Conditions are reversed during
recessions: Slack business reduces the demand for credit, in" ation falls, and the
Federal Reserve increases the supply of funds to help stimulate the economy. The
result is a decline in interest rates.Interest
Rate (%)1971 1975 1979 1983 1987 1991 1995 1999 2003 2007
Years181614121086420Long-Term RatesShort-Term RatesLong- and Short-Term Interest Rates, 1971–2007
F I G U R E 6! 2Notes:
a. The shaded areas designate business recessions.
b. Short-term rates are measured by 3- to 6-month loans to very large, strong corporations; and long-term rates
are measured by AAA corporate bonds.
Source: St. Louis Federal Reserve web site, FRED database, http://research.stlouisfed.org/fred2.