Chapter 2
Determination of Interest Rates
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Financial Markets and Institutions, 10e, Jeff Madura
Copyright ©2012by South-Western, a division of Thomson Learning. All rights reserved.
2
Chapter Outline
Loanable funds theory
Economic forces that affect interest
rates
Forecasting interest rates
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Loanable Funds Theory
Loanable funds theory suggests that
the market interest rate is determined
by the factors that affect the supply of
and demand for loanable funds
Can be used to explain movements in the
general level of interest rates of a particular
country
Can be used to explain why interest rates
among debt securities of a given country
vary
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Loanable Funds Theory
(cont’d)
Household demand for loanable funds
Households demand loanable funds to
finance
Housingexpenditures
Automobiles
Household items
There is an inverse relationship between
the interest rate and the quantity of
loanable funds demanded
Loanable Funds Theory (cont’d)
Business demand for loanable funds
Businesses demand loanable funds to invest in fixed
assets and short-term assets
Businesses evaluate projects using net present value
(NPV):
n
CFt
NPV INV
t 1 (
1 k ) t
Projects with a positive NPV are accepted
There is an inverse relationship between interest rates
and business demand for loanable funds
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Loanable Funds Theory
(cont’d)
Government demand for loanable funds
Governments demand funds when
planned expenditures are not covered by
incoming revenues
Municipalitiesissue municipal bonds
The federal government issues Treasury
securities and federal agency securities
Government demand for loanable funds is
interest-inelastic
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Loanable Funds Theory
(cont’d)
Foreign Demand for loanable funds
Foreign demand for U.S. funds is
influenced by the interest rate differential
between countries
The quantity of U.S. loanable funds
demanded by foreign governments or
firms is inversely related to U.S. interest
rates
The foreign demand schedule will shift in
response to economic conditions
8
Loanable Funds Theory
(cont’d)
Aggregate demand for loanable funds
The sum of the quantities demanded by
the separate sectors at any given interest
rate is the aggregate demand for loanable
funds
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Loanable Funds Theory
(cont’d)
Dh Db
Household Demand Business Demand
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Loanable Funds Theory
(cont’d)
Dg Dm
Federal Government Demand Municipal Government Demand
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Loanable Funds Theory
(cont’d)
Df
Foreign Demand
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Loanable Funds Theory
(cont’d)
DA
Aggregate Demand
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Loanable Funds Theory
(cont’d)
Supply of loanable funds
Funds are provided to financial markets
by
Households (net suppliers of funds)
Government units and businesses (net
borrowers of funds)
Suppliers of loanable funds supply more
funds at higher interest rates
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Loanable Funds Theory
(cont’d)
Supply of loanable funds (cont’d)
Foreign households, governments, and
corporations supply funds by purchasing
Treasury securities
Foreign households have a high savings rate
The supply is influenced by monetary
policy implemented by the Federal
Reserve System
The Fed controls the amount of reserves held
by depository institutions
The supply curve can shift in response to
economic conditions
Households would save more funds during a
strong economy
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Loanable Funds Theory
(cont’d)
SA
Aggregate Supply
Loanable Funds Theory (cont’d)
Equilibrium interest rate - algebraic
The aggregate demand can be written as
DA Dh Db Dg Dm Df
The aggregate supply can be written as
S A Sh Sb Sg Sm Sf
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Loanable Funds Theory
(cont’d)
SA
DA
Equilibrium Interest Rate - Graphic
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Economic Forces That Affect
Interest Rates
Economic growth
Shifts the demand schedule outward (to
the right)
There is no obvious impact on the supply
schedule
Supply could increase if income increases
as a result of the expansion
The combined effect is an increase in the
equilibrium interest rate
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Loanable Funds Theory
(cont’d)
SA
i2
DA2
DA
Impact of Economic Expansion
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Economic Forces That Affect
Interest Rates (cont’d)
Inflation
Shifts the supply schedule inward (to the
left)
Households increase consumption now if
inflation is expected to increase
Shifts the demand schedule outward (to
the right)
Householdsand businesses borrow more to
purchase products before prices rise
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Loanable Funds Theory
(cont’d)
SA2 S
A
i2
i
DA2
DA
Impact of Expected Increase in Inflation
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Economic Forces That Affect
Interest Rates (cont’d)
Fisher effect
Nominal interest payments compensate
savers for:
Reduced purchasing power
A premium for forgoing present
consumption
The relationship between interest rates
and expected inflation is often referred to
as the Fisher effect
Economic Forces That Affect
Interest Rates (cont’d)
Fisher effect (cont’d)
Fisher effect equation:
i E (INF ) i R
The difference between the nominal
interest rate and the expected inflation rate
is the real interest rate:
i R i E (INF )
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Economic Forces That Affect
Interest Rates (cont’d)
Money supply
If the Fed increases the money supply, the
supply of loanable funds increases
Ifinflationary expectations are affected, the
demand for loanable funds may also
increase
If the Fed reduces the money supply, the
supply of loanable funds decreases
During 2001, the Fed increased the
growth of the money supply several times
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Economic Forces That Affect
Interest Rates (cont’d)
Money supply (cont’d)
September 11
Firmscut back on expansion plans
Households cut back on borrowing plans
The demand of loanable funds declined
The weak economy in 2001–2002
Reduced demand for loanable funds
The Fed increased the money supply growth
Interest rates reached very low levels
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Economic Forces That Affect
Interest Rates (cont’d)
Budget deficit
A high deficit means a high demand for
loanable funds by the government
Shifts the demand schedule outward (to the right)
Interest rates increase
The government may be willing to pay
whatever is necessary to borrow funds, but the
private sector may not
Crowding-out effect
The supply schedule may shift outward if the
government creates more jobs by spending
more funds than it collects from the public
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Economic Forces That Affect
Interest Rates (cont’d)
Foreign flows of funds
The interest rate for a currency is
determined by the demand for and supply
of that currency
Impacted by the economic forces that affect
the equilibrium interest rate in a given
country, such as:
Economic growth
Inflation
Shifts in the flows of funds between
countries cause adjustments in the supply
of funds available in each country
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Exhibit 2.11 Flow of Funds between the
Federal Government and the Private Sector
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Economic Forces That Affect
Interest Rates (cont’d)
Explaining the variation in interest rates
over time
Late 1970s: high interest rates as a result of
strong economy and inflationary expectations
Early 1980s: recession led to a decline in interest
rates
Late 1980s: interest rates increased in response
to a strong economy
Early 1990s: interest rates declined as a result of
a weak economy
1994: interest rates increased as economic
growth increased
Drifted lower for next several years despite strong
economic growth, partly due to the U.S. budget
surplus
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Forecasting Interest Rates
Itis difficult to predict the precise
change in the interest rate due to a
particular event
Being able to assess the direction of
supply or demand schedule shifts can
help in understanding why rates changed
Forecasting Interest Rates
(cont’d)
Toforecast future interest rates, the net
demand for funds (ND) should be
forecast:
ND DA S A
Dh Db Dg Dm Df
Sh Sb Sg Sm S
f
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Forecasting Interest Rates
(cont’d)
A positive disequilibrium in ND will be
corrected by an increase in interest
rates
A negative disequilibrium in ND will be
corrected by a decrease in interest rates
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Exhibit
2.14
Framework
for
Forecastin
g Interest
Rates
