CHAPTER 2 Determination of Interest Rates © 2003 South-Western/Thomson Learning

Chapter Objectives n Explain Loanable Funds Theory of Interest Rate Determination n Identify Major Factors Affecting the Level of Interest Rates n Explain How to Forecast Interest Rates

Relevance of Interest Rate Movements n Changes in interest rates impact the real economy l Investment spending l Interest sensitive consumer spending such as housing n Interest rate changes affect the values of all securities l Security prices vary inversely with interest rates l Varying interest rates impact retirement funds and retirement income n Interest rates changes impact the value of financial institutions l Managers of financial institutions closely monitor rates l Interest rate risk is a major risk impacting financial institutions

Loanable Funds Theory of Interest Rate Determination n Theory of how the general level of interest rates are determined n Explains how economic and other factors influence interest rate changes n Interest rates determined by demand and supply for loanable funds

Loanable Funds Theory, cont. n Demand = borrowers, issuers of securities, deficit spending unit n Supply = lenders, financial investors, buyers of securities, surplus spending unit n Assume economy divided into sectors n Slope of demand/supply curves related to elasticity or sensitivity of interest rates

Sectors of the Economy n Household Sector--Usually a net supplier of loanable funds n Business Sector—Usually a net demander in growth periods n Government Sectors l States—Borrow for capital projects l Federal—Borrow for capital projects and deficit spending n Foreign Sectors—Net supplier since early 1980’s

Demand for Loanable Funds n Sum of sector demand (quantity) at varying levels of interest rates n Sector cash receipts in period less than outlays = borrower n Quantity demanded inversely related to interest rates n Variables other than interest rate changes cause shift in demand curve

Demand for Loanable Funds Interest Rate Quantity of Loanable Funds

Loanable Funds Theory l Households demand loanable funds to finance housing, automobiles, household items l These purchases result in installment debt. Installment debt increases with the level of income l There is an inverse relationship between the interest rate and the quantity of loanable funds demanded Household Demand for Loanable Funds

Loanable Funds Theory l Businesses demand loanable funds to invest in assets l Quantity of funds demanded depends on how many projects to be implemented u Businesses choose projects by calculating the project’s Net Present Value u Select all projects with +NPV’s Business Demand for Loanable Funds

Loanable Funds Theory Net Present Value is calculated as follows:  CF t (1 + k) t t = 1 n –INV + NPV = Business Demand for Loanable Funds

Loanable Funds Theory l Projects with a positive NPV are accepted because the present value of their benefits outweighs their costs l If interest rates decrease, more projects will have a positive NPV u Businesses will need a greater amount of financing u Businesses will demand more loanable funds Business Demand for Loanable Funds

Loanable Funds Theory l There is an inverse relationship between interest rates and the quantity of loanable funds demanded l The curve can shift in response to events that affect business borrowing preferences u Example: Economic conditions become more favorable u Expected cash flows will increase > more positive NPV projects > increased demand for loanable funds Business Demand for Loanable Funds

Loanable Funds Theory l When planned expenditures exceed revenues from taxes, the government demands loanable funds l Municipal (state and local) governments issue municipal bonds l Federal government and its agencies issue Treasury securities and federal agency securities. Government Demand for Loanable Funds

Loanable Funds Theory l Federal government expenditure and tax policies are independent of interest rates l Government demand for funds is interest-inelastic D Interest Rate Quantity of Loanable Funds Government Demand for Loanable Funds

Loanable Funds Theory l A foreign country’s demand for U.S. funds is influenced by the differential between its interest rates and U.S. rates l The quantity of U.S. loanable funds demanded by foreign investors will be inversely related to U.S. interest rates Foreign Demand for Loanable Funds

Loanable Funds Theory l The aggregate demand for loanable funds is the sum of the quantities demanded by the separate sectors l The aggregate demand for loanable funds is inversely related to interest rates Aggregate Demand for Loanable Funds

Sector Supply of Loanable Funds n Households are major suppliers of loanable funds n Businesses and governments may invest (loan) funds temporarily n Foreign sector a net supplier of funds in last twenty years n Federal Reserve’s monetary policy impacts supply of loanable funds

Supply of Loanable Funds n Sum of sector supply (quantity) at varying levels of interest rates n Sector cash receipts in period greater than outlays—lender n Quantity supplied directly related to interest rates n Variables other than interest rate changes causes a shift in the supply curve

Interest Rate Quantity of Loanable Funds S

Loanable Funds Theory n Equilibrium Interest Rate l Aggregate Demand D A = D h + D b + D g + D m + D f l Aggregate Supply S A = S h + S b + S g + S m + S f In equilibrium, D A = S A

Demand for Loanable Funds Supply of Loanable Funds Interest Rates Quantity of Loanable Funds Graphic Presentation

Loanable Funds Theory n Graphic Presentation l When a disequilibrium situation exists, market forces should cause an adjustment in interest rates until equilibrium is achieved u Example: interest rate above equilibrium u Surplus of loanable funds u Rate falls u Quantity supplied reduced, quantity demanded increases until equilibrium

General Equilibrium Interest Rate n Means of explaining how economic factors affect interest rate levels n Interest rate level where quantity of aggregate loanable funds demanded = supply n Surplus and shortage conditions l Surplus- Quantity demanded < quantity supplied followed by market interest rate decreases l ShortageGovernment interest rate ceilings below market interest rates

Interest Rate Changes n + Directly related to level of economic activity or growth rate of economic activity n + Directly related to expected inflation n – Inversely related to rates of money supply changes

Economic Forces That Affect Interest Rates n Economic Growth l Expected impact is an outward shift in the demand schedule without obvious shift in supply l New technological applications with +NPV’s l Result is an increase in the equilibrium interest rate

Economic Forces That Affect Interest Rates: The Fisher Effect n Lenders want to be compensated for expected loss of purchasing power (inflation) when they lend n Nominal Interest Rates = Sum of real rate plus expected rate of inflation, n Expected Real Rate (ex ante) = expected increase in purchasing power in period n Realized Real Rate (ex post) = nominal rates less actual rate of inflation in period iEIi nr =+()

Economic Forces That Affect Interest Rates n Inflation l The Fisher Effect u Nominal Interest Rates = Sum of Real Rate plus Expected Rate of Inflation inin irir E(I)+=

Figure 2.12 here

Economic Forces That Affect Interest Rates n Inflation l If inflation is expected to increase u Households may reduce their savings to make purchases before prices rise u Supply shifts to the left, raising the equilibrium rate u Also, households and businesses may borrow more to purchase goods before prices increase u Demand shifts outward, raising the equilibrium rate

Economic Forces That Affect Interest Rates n Money Supply l When the Fed increases the money supply, it increases supply of loanable funds l Places downward pressure on interest rates

Economic Forces That Affect Interest Rates n Federal Government Budget Deficit l Increase in deficit increases the quantity of loanable funds demanded l Demand schedule shifts outward, raising rates l Government is willing to pay whatever is necessary to borrow funds, “crowding out” the private sector

Economic Forces That Affect Interest Rates n Foreign Flows l In recent years there has been massive flows between countries l Driven by large institutional investors seeking high returns l They invest where interest rates are high and currencies are not expected to weaken l These flows affect the supply of funds available in each country l Investors seek the highest real after-tax, exchange rate adjusted rate of return around the world

Forecasting Interest Rates n Attempts to forecast demand/supply shifts n Forecast economic sector activity and impact upon demand/supply of loanable funds n Forecast incremental effects on interest rates n Forecasting interest rates has been difficult

Summary: Key Factors Impacting Interest Rates Over Time n Economic Growth—Increased growth; increased demand for funds; interest rates increase n Expected inflation--security prices fall; interest rates increase n Government budgets l Deficit—increase borrowing; security prices fall, interest rates increase l Surplus—decreased borrowing; security prices increase; interest rates decrease n Increased foreign supply of loanable funds—security prices increase; interest rates decrease