Unit 8. Determination of Interest Rates Movements

The loanable funds theory, is commonly used to explain interest rate movements, suggests that the market interest rate is determined by the factors that control the supply of and demand for loanable funds. The phrase “demand for loanable funds” is widely used in financial markets to refer to the borrowing activities of households, businesses, domestic governments and foreign governments and corporations. interest rate movements, suggests that the market interest rate is determined by the factors that control the supply of and demand for loanable funds.

I. Demand for Loanable Funds

(a)household demand for loanable funds; (b) corporate demand for loanable funds; (c) government demand for loanable funds; (d) foreign demand for loanable funds. Demand For Loanable funds

A. Household Demand for Loanable Funds Households commonly demand loanable funds to finance housing expenditures, automobiles and household items, which results in installment debt. There would be an inverse relationship between the interest rate and the quantity of household funds demanded. This simply implies that at any point in time, households would demand a greater quantity of loanable funds at lower rates of interest. Various events can cause household borrowing preferences to change, for example, if tax rates on household income are expected to significantly decrease in the future, households might believe that they can more easily afford future loans repayments and thus be willing to borrow more funds.

B. Business Demand for Loanable Funds Businesses demand loanable funds to invest in long-term (fixed) and short-term assets. The quantity of funds demanded by businesses depends on the number of business projects to be implemented. Businesses evaluate a project by comparing the present value of its cash flows to its initial investment. Projects with a positive net present value (NPV/净现值) are accepted because the present value of their benefits outweighs the costs. The required return to implement a given project will be lower if interest rates are lower because the cost of borrowing funds to support the project would be lower. Consequently, more projects will have positive NPVs, and businesses will need a greater amount of financing. This implies that businesses will demand a greater quantity of loanable funds when interest rates are lower.

In addition to long-term assets, businesses also invest in short-term assets (such as account receivables and inventory) in order to support ongoing operations. Any demand for funds resulting from this type of investment is positively related to the number of projects implemented and thus inversely related to the interest rate. All businesses are likely to demand more funds if interest rates are lower at a given point in time. Some events may affect the business demand for loanable funds, for instance, a lot of projects will be acceptable as a result of more favorable economic forecasts, causing an increased demand for loanable funds.

C. Government Demand for Loanable Funds Whenever a government’s expenditures can not be completely covered by its incoming revenues from taxes and other sources, it demands loanable funds, and the government will issue treasury securities, which represents government debt. The government demand for funds is said to be interest-inelastic or insensitive to interest rates. Like the household and business demand, the government demand for loanable funds are affected by various events. For instance, assume that new bills were passed that caused a net increase in the deficit of $20 billion, the government demand for loanable funds would increase by that amount, and the new demand for loanable funds would decrease if the government budget deficit were reduced.

D. Foreign Demand for Loanable funds The demand for loanable funds in a given market also includes foreign demand by foreign governments or corporations. Foreign governments and corporations would demand a larger quantity of domestic funds if their own interest rates were higher relative to domestic rates. For instance, the British government may obtain financing by issuing British treasury securities to U.S. investors, representing a British demand for U.S. funds. British demand for U.S. funds is influenced by the differential between its interest rates and U.S. rates. Therefore, for a given set of foreign interest rates, the quantity of domestic loanable funds demanded by foreign governments or firms will be inversely related to domestic interest rate.

Note: Based on the above analysis, because most of these sectors are likely to demand a larger quantity of funds at lower interest rates, the aggregate demand for loanable funds is inversely related to interest rates at any point in time.

II. Supply of Loanable Funds

(a) The household sector is the largest supplier; The term “supply of loanable funds” is commonly used to refer to funds provided to financial markets by savers. (a) The household sector is the largest supplier; (b) The loanable funds are supplied by some government units that temporarily generate more tax revenues than they spend; (c) The loanable funds are supplied by some businesses whose cash inflows exceed outflows. Supply of Loanable funds

Note: Households as a group represent a net supplier of loanable funds, whereas governments and businesses are net demanders of loanable funds.

Suppliers of loanable funds are willing to supply more funds if the interest rate (reward for supplying funds) is higher, other things being equal. A supply of loanable funds exists at even a very low interest rate because some households choose to postpone consumption until later years, even when reward (interest rate) for saving is low. Foreign households, governments, and corporations commonly supply funds to domestic markets by purchasing domestic securities. The supply of loanable funds is also influenced by the monetary policy by the domestic central bank, which controls the amount of reserves hold by depository institutions and can influence the amount of savings that can be converted into loanable funds. Note that minimal attention has been given to financial institutions in this section. Although financial institutions play a critical intermediary role in channeling funds, they do not represent the ultimate suppliers of funds. Any change in the financial institution’s supply of funds results only from a change in habits by the households, businesses or governments that supply the funds.

III. Equilibrium Interest Rate

Graph A

Graph B

In equilibrium, Da = Sa (Da represents aggregate demand and Sa represents aggregate supply): (a) If the aggregate demand for loanable funds increases without a corresponding increase in aggregate supply, there will be a shortage of loanable funds. Interest rates will rise until an additional supply of loanable funds is available to meet the excess demand. (b) If the aggregate supply of loanable funds increases without a corresponding increase in aggregate demand, there will be a surplus of loanable funds. Interest rates will fall until the quantity of funds supplied no longer exceeds the quantity of funds demanded.