Fundamentals of Financial Management (Concise 6th Edition)

Chapter 6 Interest Rates 185

countries—higher or lower rates abroad lead to higher or lower U.S. rates. Because
of all of this, U.S. corporate treasurers and everyone else who is affected by interest
rates should keep up with developments in the world economy.

6-7d Business Activity

You can examine Figure 6-2 to see how business conditions in" uence interest rates.
Here are the key points revealed by the graph:

1. Because in" ation increased from 1972 to 1981, the general tendency during
   that period was toward higher interest rates. However, since the 1981 peak,
   the trend has generally been downward.


2. The shaded areas in the graph represent recessions, during which (a) the
   demand for money and the rate of in" ation tended to fall and (b) the Federal
   Reserve tended to increase the money supply in an effort to stimulate the
   economy. As a result, there is a tendency for interest rates to decline during
   recessions. For example, the economy began to slow down in 2000, and the
   country entered a mild recession in 2001. In response, the Federal Reserve cut
   interest rates. In 2004, the economy began to rebound; so the Fed began to
   raise rates. However, the subprime debacle hit in 2007; so the Fed began low-
   ering rates in September 2007. By February, the Fed’s target rate had fallen
   from 5.25% to 3.00%, with indications that more reductions were likely.


3. During recessions, short-term rates decline more sharply than long-term
   rates. This occurs for two reasons: (a) The Fed operates mainly in the short-
   term sector, so its intervention has the strongest effect there. (b) Long-term
   rates re" ect the average expected in" ation rate over the next 20 to 30 years;
   and this expectation generally does not change much, even when the current
   in" ation rate is low because of a recession or high because of a boom. So
   short-term rates are more volatile than long-term rates. Taking another look
   at Figure 6-2, we see that short-term rates did decline recently by much more
   than long-term rates.

6-8 INTEREST RATES AND BUSINESS DECISIONS

The yield curve for January 2008 shown earlier in Figure 6-4 indicates how much
the U.S. government had to pay in January 2008 to borrow money for 1 year,
5 years, 10 years, and so forth. A business borrower would have paid somewhat
more, but assume for the moment that it is January 2008 and the yield curve shown
for that year applies to your company. Now suppose you decide to build a new
plant with a 30-year life that will cost $1 million and you will raise the $1 million
by borrowing rather than by issuing new stock. If you borrowed in January 2008
on a short-term basis—say for 1 year—your annual interest cost would be only
2.7%, or $27,000. On the other hand, if you used long-term! nancing, your annual
cost would be 4.3%, or $43,000. Therefore, at! rst glance, it would seem that you
should use short-term debt.

SEL

F^ TEST Identify some macroeconomic factors that in" uence interest rates and ex-

plain the e! ects of each.

How does the Fed stimulate the economy? How does the Fed a! ect interest

rates?

Does the Fed have complete control over U.S. interest rates? That is, can it set

rates at any level it chooses? Why or why not?