1. DETERMINATION OF INTEREST RATES
CHAPTER 2
DETERMINATION OF INTEREST RATES 1
Dr. David P. Echevarria
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2. Interest rates ECB – European Union
ECN-324
Financial Markets and Institutions

3. 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 

4. 2016: 10 yr: % Pay €1000 get back €987.87

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

6. US Treasury Yield Curve 8/21/2017 10 Yield: 2
US Treasury Yield Curve 8/21/ Yield: 2.18% (= $218 / $1000 of Face Value)
Dr. David P. Echevarria
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7. Money Follows Opportunity….

8. 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

9. 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
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10. 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
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11. 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
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12. 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
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13. 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
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14. 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
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15. 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
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