1. How rates are determined The Term Structure
Interest Rates II:
How rates are determined
The Term Structure
Money & Banking - ECO Dr. D. Foster

2. The Loanable Funds Theory
Real interest rates (r) are determined by the supply and demand for loans.
Demand = investment.
Supply = saving + net K flows
K inflow - foreigners saving here.
K outflow - we are saving abroad. 2

3. The Market for Loanable Funds3

4. The Liquidity Preference Theory
The nominal interest rate (i) is determined by the supply and demand for money.
Money supply = MS and is determined by the Federal Reserve.
Money demand = MD and is used for exchange purposes.
But, i=opportunity cost of holding money.
Consumers weigh benefits & costs. 4

5. The “Market” for Money 5

6. Why do Interest Rates differ?
Default risk
(Il)liquidity risk
“Risk premium” = i - iT-Bill
Adjusting for risk premiums, i still differs …
by maturities; aka “term structure of interest rates.”
a positive “term premium”  normal yield curve.
a negative “term premium”  inverted yield curve.

7. Causes of the term structure
Segmented markets
Different terms are not good substitutes.
Expectations
If we expect r to rise, longer-term bonds will earn a higher interest rate.
Preferred habitat
Longer terms require a premium usually.
[Unanticipated] Inflation premium (ua). . .

8. Unanticipated Inflation Premium
Consider a 1 yr. bond and a perpetuity
Bond
$1000
$50
Perpetuity
If i=5%; with 2% for expected inflation (πe), then:
Bond price = $1050/1.05 = $1000
Perpetuity price = $50/.05 = $1000

9. Unanticipated Inflation Premium
What if actual inflation () rises to 4%?
The bond price will fall to $1050/1.07 = $981.30
The perpetuity price falls to $50/.07 = $714.30
So, we may interpret the “normal” yield curve with respect to unanticipated inflation (ua):
Longer terms command higher yields to account for this asymmetric risk.

10. What if Inflation is Correctly Anticipated?
As with expected interest rate changes, no reason to favor one outcome here.
The yield curve will reflect that:
Maturity
Yield
Expect rising inflation
Expect falling inflation
Expect constant inflation

11. Negative Interest Rate Policy
Central Banks start charging interest on bank reserves
-- Purpose? Stimulate lending/spending/econ. activity
Will the Federal Reserve follow suit?
-- They have been paying interest on reserves!
-- They want to raise interest rates!
-- Their policy is rooted in fear of spending!
Will bank depositors be next?
-- This will lead to Deposits and Cash!
-- This will raise transaction costs!
-- The next step – prohibit cash!

12. How rates are determined The Term Structure
Interest Rates II:
How rates are determined
The Term Structure
Money & Banking - ECO Dr. D. Foster