FIN203

Lecture 7a

Topic 9 & 10

Monetary analysis,
Determinants of Interest
Rates and Term Structure
of Interest
McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
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To understand the important roles that
interest rates play within the economy.
To explore the most important ideas
about what determines the level of
interest rates and asset prices within
the financial system.
To learn what economists believe are
the key forces that set market interest
rates and asset prices into motion.
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 Functions of the Central
Banks
 Clear checks
 Issue new currency
 Withdraw damaged currency from circulation
 Administer and make discount loans to banks
in their districts
 Evaluate proposed mergers and applications
for banks to expand their activities
 Goals of Monetary Policy

 Goals
─ Stable prices
─High employment
─Economic growth
─Stability of financial markets
─Interest-rate stability
─Foreign exchange market stability
 Goals often in conflict
 Monetary Tools

 Tools of Monetary Policy

 Discount Policy
 Reserve Requirements
 Monetary Policy Tools of the CB
 The Price Stability Goal and the Nominal
Anchor
 Other Goals of Monetary Policy
 Tools of Monetary Policy:
Open Market Operations

 Open Market Operations

1.Dynamic: Meant to change Reserves
2.Defensive: Meant to offset other factors
affecting Reserves, typically uses repos
 Advantages of Open Market Operations
1.CB has complete control
2.Flexible and precise
3.Easily reversed
4.Implemented quickly
 Discount Policy

 The Fed’s discount loans are primarily of

three types:
─Primary Credit: Policy whereby healthy banks
are permitted to borrow as they wish from the
primary credit facility.
─Secondary Credit: Given to troubled banks
experiencing liquidity problems.
─Seasonal Credit: Designed for small, regional
banks that have seasonal patterns of deposits.
 Discount Policy

 Lender of Last Resort Function

─To prevent banking panics
─Example: Continental Illinois
 Really needed? What about the FDIC?
─Problem 1: FDIC only has about 1% of deposits
in the insurance trust—people need the Fed for
additional confidence in the system
─Problem 2: over $1.8 trillion are large deposits
not insured by the FDIC
 Reserve Requirements and Moral
Suasion

Reserve Requirements in US are requirements put on

financial institutions to hold liquid (vault) cash again
checkable deposits.
 Everyone subject to the same rule for checkable
deposits:
 3% of first $48.3M, 10% above $48.3M
 Fed can change the 10%
 Rarely used as a tool
 Raising causes liquidity problems for banks
 Makes liquidity management unnecessarily difficult
 Moral Suasion
 Topic 9

Term Structure of Interest

 Interest Rate

 The acts of saving and lending, and

borrowing and investing, are
significantly influenced by and tied
together by the interest rate.
 The interest rate is the price a borrower
must pay to secure scarce loanable
funds from a lender for an agreed-upon
time period. Some refer to this as the
price of credit.
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 Interest Rate
 The rate of interest is a ratio of the
money cost of borrowing divided by the
money actually borrowed.
 Interest rates send price signals to
borrowers, lenders, savers, and
investors.
 Whether higher interest rates increase
or decrease savings and investment
depends on the relative strength of its
effect on supply and demand factors.
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 Functions of the Interest Rate
in the Economy
 Rate of Interest
 Helps guarantee that current savings flow
into investment to promote economic
growth
 Generally allocates the available supply of
credit to investment projects with the
highest expected returns
 Balances the supply of money with the
public’s demand for money
 Tool of government policy

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 The Interest Rate
 Common reference to ―the interest rate‖
 Multiple rates in economy
 Even securities by the same borrower can
have differing rates
 Focus on forces that impact all rates
 Assume a single fundamental rate
 Pure interest rate
 Risk-free rate of interest
 Opportunity cost of holding cash
 Closest real-world equivalent is top rated
government bonds rate
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 The Classical Theory of Interest Rates

 The classical theory is one of the oldest

interest rate theories
 Rate of interest is determined by the
balance of two forces
 Supply of savings, derived mainly from
households
 Demand for investment capital, coming
mainly from the business sector

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 Wealth Effect

Timing and amount of savings

 Current income and expected future income
 Desired savings target
 Propensity to save
 Wealth
Wealth effect
 Greater wealth tends to raise consumption
 Strong during the late 1990s
 Stock market and housing boom
 Personal savings rate was negative
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The Classical Theory of Interest Rates

The Substitution Effect

Relating Savings and Interest Rates
Interest
Rate
r2 
r1 

Current
S1 S2 Saving

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 The Classical Theory of Interest Rates

 Business savings
 Savings balances in form of retained earnings
 Primary financing for business investment
 Principally determined by profits
 Interest rates also impact savings

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 The Classical Theory of Interest Rates

Government savings
 When the government has a budget
surplus
 Major determinants
 Income flows in the economy
 Pacing of government spending
 Rates impact cost of government debt

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 The Classical Theory of Interest Rates

 Demand for investment funds

 Primarily for businesses
 Gross business investment equals the
sum of replacement investment and net
investment
 One investment decision-making method
involves the calculation of a project’s
expected internal rate of return, and the
comparison of that expected return with
the anticipated returns of alternative
projects, as well as with market interest
rates
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The Classical Theory of Interest Rates

The Investment Demand Schedule

In the Classical Theory of Interest Rates
Interest
Rate
r2 
r1 

Investment
I2 I1 Spending

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The Classical Theory of Interest Rates

The Equilibrium Rate of

Interest In the Classical Theory
Rate of
interest Demand for
(% per S
D Investment
annum)
Volume
E
of Savings
rE 

S D

QE = $200 billion
Volume of savings & investment ($billions)

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 The Classical Theory of Interest Rates

 Limitations
 Ignores factors other than savings and
investment that affect interest rates
 For example, many financial institutions
can ―create‖ money today by making
loans
 Repaying the loan ―destroys‖ money
 Income and wealth are more important
than interest rates in determining savings
 Traditionally businesses primary borrower
 Now consumers major borrowers
 Now governments major borrowers
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 The Liquidity Preference (Cash Balances)
Theory of Interest Rates

 The liquidity preference (or cash

balances) theory of interest rates
 Short-term theory
 Developed for explaining near-term
changes in interest rates
 More relevant for policymakers

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The Liquidity Preference (Cash Balances)
Theory of Interest Rates

 Rate of interest is the payment

 For the use of their scarce resource
(liquidity)
 By those who demand liquidity
 Assumed outlet for funds
 Bonds
 Cash Balances
 There are three elements of demand for
cash balances

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 The Liquidity Preference (Cash Balances)
Theory of Interest Rates
 Transactions motive
 Economic units do not have a perfect
balance of inflows and outflows
 Hold liquidity for purchase of goods and
services
 Not overly sensitive to interest rates
 Transactions demand in earlier theory
 Dependent on level of national income
 Dependent on business sales
 Dependent on prices
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The Liquidity Preference (Cash Balances)
Theory of Interest Rates

Precautionary motive
 Cannot predict future expenditures
precisely
 Cope with future emergencies
 Cover potential extraordinary
expenses
 E.g. unanticipated medical expense
 Greater in times of economic uncertainty
 Not overly sensitive to interest rate
movements
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The Liquidity Preference (Cash Balances)
Theory of Interest Rates

Speculative motive
 Demand due to uncertainty in future
bond prices
 Change in interest rates
 Changes bond prices
 Demand for cash balances substitute
for bonds
 High interest rates lead to high
opportunity cost of holding cash

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Speculative Demand for Money or
Cash Balances

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 The Liquidity Preference (Cash
Balances) Theory of Interest Rates
 Modern governments control or closely
regulate money supply
 Decisions concerning the size of the
money supply presumably guided by the
public welfare
 So assume the supply of money (cash
balances) is inelastic with respect to
interest rates
 Represented by a vertical supply curve in
the equilibrium
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Total Demand for Money or Cash Balances
And the Equilibrium Rate of Interest

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 The Liquidity Preference (Cash Balances)
Theory of Interest Rates

Quantity of money demanded by public

equals supply provided by government
If the supply exceeds quantity demanded
at current interest rates
 Buy bonds with excess funds
 Decrease cash balances
 Increase bond prices and lower interest rates
Useful insights
 Rational at times to hoard or dishoard cash
 Shows how central banks impact the markets5-32
 The Liquidity Preference (Cash Balances)
Theory of Interest Rates
 Limitations
 The liquidity preference theory is a short-
term theory
 Assumption that income remains stable
does not hold in the long-term
 Only the supply and demand for money is
considered
 Fails to consider the supply and
demand for credit by all actors in
financial system
 businesses, households, and
governments
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 The Loanable Funds Theory of Interest

 Loanable funds theory

 Most popular practitioner theory
 Risk-free interest rate is determined by the
interplay of two forces
 the demand for credit (loanable funds),
domestic businesses, consumers, and
governments, as well as foreign borrowers
 the supply of loanable funds from domestic
savings, dishoarding of money balances,
money creation by the banking system, as well
as foreign lending
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 The Loanable Funds Theory of Interest

 The Demand for loanable funds

 Consumer (household) demand is relatively
inelastic with respect to the rate of interest
 Domestic business demand increases as the
rate of interest falls
 Government demand does not depend
significantly upon the level of interest rates
 Foreign demand is sensitive to the spread
between domestic and foreign interest rates

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 The Loanable Funds Theory of Interest

 The supply of loanable funds

 Domestic savings. The net effect of
income, substitution, and wealth effects is
a relatively interest-inelastic supply of
savings curve
 Dishoarding of money balances. When
individuals and businesses dispose of
their excess cash holdings, the supply of
loanable funds available to others is
increased

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 The Loanable Funds Theory of Interest

 The supply of loanable funds

… continued
 Creation of credit by the domestic banking
system. Commercial banks and nonbank
thrift institutions offering payments
accounts can create credit by lending and
investing excess reserves
 Foreign lending sensitive to the spread
between domestic and foreign rates
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The Loanable Funds Theory of Interest

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 The Loanable Funds Theory of Interest

 At equilibrium:
 Planned savings = planned investment
across the whole economic system
 Money supply = money demand
 Supply of loanable funds = demand for
loanable funds
 Net foreign demand for loanable funds =
net exports

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 The Loanable Funds Theory of Interest

 Interest rates will be stable only when

the economy, money market, loanable
funds market, and foreign currency
markets are simultaneously in
equilibrium.

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Changes in the Demand for and Supply of
Loanable Funds

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Changes in the Demand for and Supply of
Loanable Funds

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 Inflation and Interest Rates

Alternative views
 The Fisher effect
 Among the most popular explanations
 Examining the linkages between inflation and
interest rates
 i = r + pe
ie, nominal interest rate (i)=real interest® plus
expected inflation(pe)
 Several alternative views have emerged over
the years
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 Inflation and Interest Rates

Anticipated versus unanticipated inflation

 Fisher effect had a major drawback
 It failed to distinguish between anticipated (or
expected) and unanticipated (or unexpected)
inflation
 Fisher assumes all inflation anticipated
 There is no way to be certain about what the
equilibrium nominal interest rate will be if this is
violated

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 Inflation and Interest Rates

The Inflation risk premium

 Inflation risk premium represents
compensation paid to a lender for that
component of inflation that is not expected
 Recent research suggested that the inflation-
interest rate equation may look more like:
nominal interest rate = real interest rate
+ expected inflation rate
+ inflation risk premium

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 Inflation and Interest Rates

Nominal and real interest rates

 Nominal rate of interest
 Quoted rate
 Real rate of interest
 Rate measured in terms of purchasing power
 Will be below the nominal rate when there is inflation
 Inflation premium
 The rate of inflation expected by lenders and
investors during the life of an instrument

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 The Rational Expectations
Theory of Interest

 The rational expectations theory builds

on a growing body of research
evidence that the money and capital
markets are highly efficient in digesting
new information that affects interest
rates and security prices.

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 The Maturity of a Loan

 The unbiased expectations hypothesis argues

that investor expectations regarding future
changes in short-term rates determine the
shape of the curve
 If short-term rates are currently below long-term
rates, then the short rate is expected to rise in the
future
 The reverse is also true

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 The Maturity of a Loan

 The liquidity premium view of the yield curve

suggests that there is a bias toward
positively-sloped yield curves
 Longer-term securities tend to have more volatile
market prices
 Longer-term securities tend to have greater risk of
capital loss
 Investors must be paid an interest rate premium
(the liquidity premium) to encourage them to
purchase long-term securities

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 The Segmented-Markets and
Preferred Habitat Arguments
 The market segmentation argument
 The financial markets are separated into several
distinct markets
 According to the maturity preferences of the investors
 Governments can alter the shape of the yield curve
 Shifting the available supplies of securities relative to the
demand for those securities
 In each distinct market

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 The Segmented-Markets and
Preferred Habitat Arguments
 The preferred habitat or composite theory of
the yield curve argues that investors seek out
their preferred habitat
 They choose securities that match their needs
 Risk preferences
 Tax exposure
 Liquidity needs
 Regulatory requirements
 Planned holding periods

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 The Segmented-Markets and
Preferred Habitat Arguments

 An investor will not normally stray from his

or her preferred habitat
 Unless the rates of return on some other
securities are higher
 Enough to overcome his or her preferences
 Investors derive expectations from looking at
history

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 Research Evidence on
Yield Curves
 Empirical studies on the various yield curve
theories have produced mixed results
 Recent research has delved more deeply into
individual events
 What kinds of events cause the yield curve’s
overall shape to change
 Statistically, yield curves may change along any
of at least three different dimensions: level, slope,
or curvature

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 Uses of the Yield Curve

 The yield curve is a useful tool for …

 forecasting interest rates – a downward-sloping yield
curve suggests near-term declines in rates
 identifying portfolio management strategies – a rising
yield curve favors short-term borrowing and long-term
lending
 detecting over- and under-priced financial assets
 indicating trade-offs between maturity and yield
 ―riding‖ the yield curve – active investors may gain by
timely portfolio switching

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 Summary

We examined the different theories of

Interest rate determination