1. 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.

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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

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

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

11. Loanable Funds Theory (cont’d)Df
Foreign Demand

12. Loanable Funds Theory (cont’d)DA
Aggregate Demand

13. 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

14. 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

15. Loanable Funds Theory (cont’d)SA
Aggregate Supply

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

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

18. 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

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

20. 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

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

22. 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

23. 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:

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. Forecasting Interest Rates (cont’d)
To forecast future interest rates, the net demand for funds (ND) should be forecast:

31. 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