Mohammed Shahed Rajon Topic # 02 Determination of Interest Rate BBA(Hons.), MBA(Finance & Banking), M.Phil(CU) Assistant Professor Mohammad Shahed Rajon www.studyandjobs24.com 1

Economic forces that affect interest rates Chapter Contents Loanable fund theory; Demand for loan able funds (Da); Supply for loan able funds (Sa); Equilibrium Interest rate Economic forces that affect interest rates Mohammad Shahed Rajon www.studyandjobs24.com

Loan able Funds Theory The loan able funds theory commonly used to explain interest rate movements. It suggests that the market interest rate is determined by the factors that control the supply and demand for loan able funds. The theory is especially useful for explaining movements in the general level of interest rates for a particular country. Mohammad Shahed Rajon www.studyandjobs24.com

Loan able Funds Theory (Con.) Finally, the demand and supply concepts are integrated to explain interest rate movements. That's are- Demand for loan able funds (Da) B. Supply for loan able funds (Sa) C. Equilibrium Interest rate Mohammad Shahed Rajon www.studyandjobs24.com

A. Demand for loan able funds (Da) 1. House hold demand for loan able funds (Dh) 2. Business demand for loan able funds (Db) 3. Government demand for loan able funds (Dg) 4. Foreign demand for loan able funds (Gf) 5. Aggregate demand for loan able funds Mohammad Shahed Rajon www.studyandjobs24.com

B. Supply for loan able funds (Sa) 1. Households Supply for loan able funds (Sh) 2. Business Supply for loan able funds (Sb) 3. Government Supply for loan able funds (Sg) 4. Foreign Supply for loan able funds (Sf) 5. Aggregate Supply for loan able funds C. Equilibrium Interest rate Mohammad Shahed Rajon www.studyandjobs24.com

A. Demand for loan able funds Demand for loan able funds depends few factors. Those factors are discussed follows- House hold demand for loan able funds (Dh): Households commonly demand loan able funds to finance housing expenditures. In addition, they finance the purchases of different household items, which results in installment debt. If interest rate is low then household demand of loan able fund is high. Normally households demand is small and lower than business demand. Mohammad Shahed Rajon www.studyandjobs24.com

2. Business demand for loan able funds (Db): Business demand loan able funds to invest in long term and short term assets. The quantity of funds demanded by business 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. Normally business demand of loan able fund is higher than household demand. NPV= - Investment + ∑ CFn / (1+ k) n Mohammad Shahed Rajon www.studyandjobs24.com

Problem: Investment of a project Tk Problem: Investment of a project Tk. 50,000, interest rate 10%, cash flows are given as Tk. 25,000, Tk. 22,000 and Tk. 28,000. Find out NPV of this project to determine the loan able demand. Ans. Tk. 11,946; no demand of loan able fund of this project in this time. Mohammad Shahed Rajon www.studyandjobs24.com

3. Government demand for loan able funds (Dg): Whenever a government’s planned expenditures cannot be completely covered by its incoming revenues from taxes and other sources, it demands loan able funds. Municipal Government Issue municipal bond to obtain funds, while the federal government and its agencies issue treasury securities and federal agency securities. These securities represent government debt. Mohammad Shahed Rajon www.studyandjobs24.com

4. Foreign demand for loan able fund (Df): The demand for loan able funds in a given market also includes foreign demand by foreign government or corporation. The foreign demand schedule can shift in response to economic conditions. Mohammad Shahed Rajon www.studyandjobs24.com

5. Aggregate demand for loan able funds (Da): The aggregate demand for loan able fund is the sum of the quantities by the separate sectors at any given interest. Most of these sectors are likely to demand a larger quantity of funds at lower interest rates, aggregate demand for loan able funds is inversely related to interest rates at any point in time. It represent by- Da= Dh+ Db + Dg + Df Mohammad Shahed Rajon www.studyandjobs24.com

B. Supply for loan able funds Supply of loan able funds is commonly used to refer to funds provided to financial markets by savers. Supply for loan able funds depends few factors. Those factors are discussed follows- 1. House hold Supply for loan able funds (Sh): Household sector is the largest supplier of loan able funds. Households as a group, they are the great supplier of loan able funds. Mohammad Shahed Rajon www.studyandjobs24.com

2. Business supply for loan able funds (Sb): Some businesses whose cash inflows exceed outflows are the supply for loan able funds. Normally they are the small supplier for loan able funds. 3. Government supply for loan able funds (Sg): Loan able funds are also supplied by some government units that temporarily generate more tax revenues than they spend. Mohammad Shahed Rajon www.studyandjobs24.com

4. Foreign supply for loan able fund (Sf): Foreign households, government and corporations commonly supply funds to their domestic securities. 5. Aggregate supply for loan able funds ( Sa) : The aggregate supply schedule of loan able funds represents the combination of all sector supply schedules. It represent by- Sa= Sh + Sb + Sg + Sf Mohammad Shahed Rajon www.studyandjobs24.com

C. Equilibrium Interest Rate The equilibrium interest rate is the rate that equates the aggregate demand for funds with the aggregate supply of loan able funds. That can be written as- Da =Sa Dh+ Db + Dg + Df = Sh + Sb + Sg + Sf Mohammad Shahed Rajon www.studyandjobs24.com

Economic forces that affect interest rates It is necessary to recognize the underlying economic forces that cause a change in the supply or the demand for loan able funds. Few economic forces are – economic growth, inflation, money supply, budget deficit and foreign flows of funds. The following economic factors influence the demand for or supply of loan able funds and therefore influence interest rate- Mohammad Shahed Rajon www.studyandjobs24.com

Economic forces that affect interest rates (Con.) Impact of economic growth on interest rates Impact of inflation on interest rates Impact of money supply on interest rates Impact of budget deficit on interest rates Impact of foreign flows of funds on interest rates Those are discuss below- Mohammad Shahed Rajon www.studyandjobs24.com

1. Impact of economic growth on interest rates More optimistic economic projections, most businesses increase their planned expenditures for expansion, which translates into additional borrowing. EG increase IR decrease EG decrease IR increase Mohammad Shahed Rajon www.studyandjobs24.com

2. Impact of inflation on interest rates Inflation can affect interest rates because of its effect on the supply of savings and demand for loan able funds. Inf increase IR increase Inf decrease IR decrease Mohammad Shahed Rajon www.studyandjobs24.com

3. Impact of money supply on interest rates Bangladesh Bank can affect the supply of loan able funds by increasing or reducing the total amount of deposits held at commercial banks or other depository institutions. MS increase IR decrease MS decrease IR increase Mohammad Shahed Rajon www.studyandjobs24.com

4. Impact of budget deficit on interest rates The government’s fiscal policy result is more expenditure than the revenue and then budget deficit is increased. BD increase IR increase BD decrease IR decrease Mohammad Shahed Rajon www.studyandjobs24.com

5. Impact of foreign flows of funds on interest rates The interest rate for a specific currency is determined by the demand for funds denominated in that currency and the supply of loan able funds available in the currency. FF increase IR decrease FF decrease IR increase Mohammad Shahed Rajon www.studyandjobs24.com