CP

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 first and second mortgages and for loans on single-

family homes, apartments, office buildings, shopping centers, vacant land, and so on.

Within the business sector there are dozens of types of debt and also several different

markets for common stocks.

There is a price for each type of capital, and these prices change over time as shifts

occur in supply and demand conditions. Figure 1-4 shows how long- and short-term

interest rates to business borrowers have varied since the early 1960s. Notice that

short-term interest rates are especially prone to rise during booms and then fall dur-

ing recessions. (The shaded areas of the chart indicate recessions.) When the economy

is expanding, firms need capital, and this demand for capital pushes rates up. Also, in-

flationary pressures are strongest during business booms, and that also exerts upward

pressure on rates. Conditions are reversed during recessions such as the one in 2001.

Slack business reduces the demand for credit, the rate of inflation falls, and the result

is a drop in interest rates. Furthermore, the Federal Reserve deliberately lowers rates

during recessions to help stimulate the economy and tightens during booms.

These tendencies do not hold exactly—the period after 1984 is a case in point.

The price of oil fell dramatically in 1985 and 1986, reducing inflationary pressures

Interest Rate Levels 29

FIGURE 1-4 Long- and Short-Term Interest Rates, 1962–2001

Interest Rate

(%)

Long-Term

Rates

Short-Term

Rates

1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991

18

16

14

12

10

8

6

4

2

0

1993 1995 1997 1999 2001

18

16

14

12

10

8

6

4

2

0

Notes:
a. The shaded areas designate business recessions.
b. Short-term rates are measured by three- to six-month loans to very large, strong corporations, and long-term rates are measured by AAA corporate
bonds.
Sources:Interest rates are from theFederal Reserve Bulletin;seehttp://www.federalreserve.gov/releases.The recession dates are from the National
Bureau of Economic Research;seehttp://www.nber.org/cycles.As we write this (winter 2002), the economy is in yet another recession.

An Overview of Corporate Finance and the Financial Environment 27