Determination of Interest Rates Chapter 2 Determination of Interest Rates Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

Chapter Outline Loanable funds theory Economic forces that affect interest rates Forecasting interest rates

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

Loanable Funds Theory (cont’d) Household demand for loanable funds Households demand loanable funds to finance Housing expenditures 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): Projects with a positive NPV are accepted There is an inverse relationship between interest rates and business demand for loanable funds

Loanable Funds Theory (cont’d) Government demand for loanable funds Governments demand funds when planned expenditures are not covered by incoming revenues Municipalities issue municipal bonds The federal government issues Treasury securities and federal agency securities Government demand for loanable funds is interest-inelastic

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

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

Loanable Funds Theory (cont’d) Dh Db Household Demand Business Demand

Loanable Funds Theory (cont’d) Dm Dg Federal Government Demand Municipal Government Demand

Loanable Funds Theory (cont’d) Df Foreign Demand

Loanable Funds Theory (cont’d) DA Aggregate Demand

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

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

Loanable Funds Theory (cont’d) SA Aggregate Supply

Loanable Funds Theory (cont’d) Equilibrium interest rate - algebraic The aggregate demand can be written as The aggregate supply can be written as

Loanable Funds Theory (cont’d) SA i DA Equilibrium Interest Rate - Graphic

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

Loanable Funds Theory (cont’d) SA i2 i DA2 DA Impact of Economic Expansion

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) Households and businesses borrow more to purchase products before prices rise

Loanable Funds Theory (cont’d) SA2 SA i2 i DA2 DA Impact of Expected Increase in Inflation

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: The difference between the nominal interest rate and the expected inflation rate is the real interest rate:

Economic Forces That Affect Interest Rates (cont’d) Money supply If the Fed increases the money supply, the supply of loanable funds increases If inflationary 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

Economic Forces That Affect Interest Rates (cont’d) Money supply (cont’d) September 11 Firms cut 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

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

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

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

Forecasting Interest Rates It is 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) To forecast future interest rates, the net demand for funds (ND) should be forecast:

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