DETERMINATION OF INTEREST RATES CHAPTER 2 DETERMINATION OF INTEREST RATES 1 Dr. David P. Echevarria All Rights Reserved All Rights Reserved

Interest rates ECB – European Union ECN-324 Financial Markets and Institutions

Euro area yield curve The euro area yield curve shows separately AAA-rated euro area central government bonds and all euro area central government bonds (including AAA-rated). A yield curve is a representation of the relationship between market remuneration rates and the remaining time to maturity of debt securities. A yield curve can also be described as the term structure of interest rates. The ECB publishes several yield curves, as shown to the right 

2016: 10 yr: -0.122% Pay €1000 get back €987.87

US Treasury Yield Curve 8/22/2016 10 Yr: 1 US Treasury Yield Curve 8/22/2016 10 Yr: 1.56% (coupon) = $156 in interest (total)

US Treasury Yield Curve 8/21/2017 10 Yield: 2 US Treasury Yield Curve 8/21/2017 10 Yield: 2.18% (= $218 / $1000 of Face Value) Dr. David P. Echevarria All Rights Reserved

Money Follows Opportunity….

Implications of Concave Yield Curve Normal Yield Curve (Convex) Increase in risk → Increase in return* Concave Yield Curve Increase in risk → Increase in return << Normal curve Implication: risk taking is less valuable May account for decline in new business formations and increase in failure rates

The Supply and Demand for Credit Interest Rates reflect the cost of credit (borrowing). The movement of interest rates is determined by: Supply of Credit and the Demand for same. Increases in supply, ceteris paribus, leads to lower interest rates. Increases in Demand, ceteris paribus, leads to lower interest rates. Interest rates are positively affected by inflationary expectations: Inflation ↑ Rates ↑ Interest rates are also affected by risk perceptions All Rights Reserved

SUPPLY OF LOANABLE FUNDS Households are net suppliers of funds. Governments may also supply funds* The Fiscal Year 2009 Stimulus generated approximately $800 Billion in credit (debt). Federal Reserve Monetary Policy Reduce reserve requirement Buy Securities from member banks 10 Dr. David P. Echevarria All Rights Reserved All Rights Reserved

DEMAND FOR LOANABLE FUNDS Households Consumption above current income levels financed with borrowing. Business Finance asset expansion. Government Cover expenditures in excess of tax receipts. Demand for funds Inelastic with respect to rates. Foreign Same reasons as "A" and "B" as well as "C" Additional sources of [FOREX] risk 11 Dr. David P. Echevarria All Rights Reserved All Rights Reserved

EQUILIBRIUM INTEREST RATE Equilibrium = point at which markets clear (no excess supply or demand). Question: Is an equilibrium point observable? Question: Is equilibrium an important concept? Changes in the Equilibrium Interest Rate Change in response to changes in supply of funds Change in response to changes in demand for funds The Fisher Effect Preserving Purchasing Power Components of the Nominal Rate of Interest 12 Dr. David P. Echevarria All Rights Reserved All Rights Reserved

KEY ISSUES REGARDING INTEREST RATES Government Budget Deficits and Interest Rates Does government competition for loanable funds increase the cost? What arguments support deficit spending? Impact of Foreign Interest Rates Mobility of international capital → domestic rates Differences in international investment opportunity sets Impact of Exogenous Events on Interest Rates Unexpected international events: wars and rumors of war Sovereign debt crises 13 Dr. David P. Echevarria All Rights Reserved All Rights Reserved

FRAMEWORK FOR FORECASTING INTEREST RATES Factors in forecasts: (see Ex 2.14) Foreign demand (vs. foreign supply) Household demand (vs. household supply) Business demand Depends on investment opportunity set Government demand Fiscal Policy drives borrowing Fiscal Policy a function of economic policy goals 14 Dr. David P. Echevarria All Rights Reserved All Rights Reserved

HOMEWORK QUESTIONS Whom demands and supplies funds in the Loanable Funds Theory? How does the supply of and demand for money [credit] impact interest rates? What causes changes in interest rates? What is the Fisher Effect and why is it important? What exogenous forces affect interest rates? 15 Dr. David P. Echevarria All Rights Reserved All Rights Reserved