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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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.
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10. 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.
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11. 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.
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12. 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

13. 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

14. 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

15. 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
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16. 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
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17. 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-
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18. 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-
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19. 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
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20. 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
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21. 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

22. 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
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23. 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