Money and Capital Markets

5
C h a p t e r
Eighth Edition
Financial Institutions and Instruments in a Global Marketplace
Peter S. Rose
McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu
The Determinants of Interest Rates:
Competing Ideas
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
5 - 2
Learning Objectives
To understand the important roles and
functions that interest rates perform within the
economy and the financial system.
To explore the most important ideas about the
determinants of interest rates and asset prices.
To identify the key forces that economists
believe set market interest rates and asset
prices into motion.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
5 - 3
Introduction
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.
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5 - 4
Functions of the Interest Rate in the Economy
The interest rate helps guarantee that current
savings will flow into investment to promote
economic growth.
It rations the available supply of credit,
generally providing loanable funds to those
investment projects with the highest return.
It brings the supply of money into balance with
the publics demand for money.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
5 - 5
Functions of the Interest Rate in the Economy
The interest rate serves as an important tool for
government policy, through its influence on
the volume of savings and investment.
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5 - 6
Pure or risk-free rate of interest is one fundamental
interest rate by assumption.

The pure or risk-free rate of interest is a component
of all interest rates.

While the pure or risk-free rate of interest exists only
in theory, the closest real-world approximation to this
pure rate of return is the market interest rate on
government bonds.

Functions of the Interest Rate in the Economy
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The Classical Theory of Interest Rates
The classical theory argues that the rate of
interest is determined by two forces:
Volume of Savings, Coming mainly from
Households.
the demand for investment capital, coming mainly
from the business sector.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
5 - 8
The Classical Theory of Interest Rates
Household Savings
Current household savings equal the difference
between current income and current
consumption expenditures. It depends on the
following:
Income effect
Substitution effect
Wealth effect
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5 - 9
The Classical Theory of Interest Rates
The Substitution Effect
Relating Savings and Interest Rates
Interest
Rate
Current
Saving

r
1

S
1


r
2

S
2

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5 - 10
The Classical Theory of Interest Rates
Business and Government Savings
Most businesses hold savings balances in the
form of retained earnings, the amount of
which is determined principally by business
profits, and to a lesser extent, by interest rates.
Income flows in the economy and the pacing
of government spending programs are the
dominant factors affecting government savings
(budget surplus).
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
5 - 11
The Classical Theory of Interest Rates
The Demand for Investment Funds
Gross business investment equals the sum of
replacement investment and net investment.
The investment decision-making process
typically involves the calculation of a projects
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.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
5 - 12
The Classical Theory of Interest Rates
The Cost of Capital and the Investment Decision
A
15%
B
12%
C
10%
D
8%
E
7%
Dollar Cost of Investment Projects
Expected
Internal
Rates of
Return on
Alternative
Investment
Projects
Cost of
Capital
Funds
= 10%
C
10%
D
8%
E
7%
acceptable
acceptable
indifferent
unprofitable
unprofitable
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5 - 13
The Classical Theory of Interest Rates
The Investment Demand Schedule
In the Classical Theory of Interest Rates

r
2

Interest
Rate
Investment
Spending

r
1

I
1
I
2

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5 - 14
The Classical Theory of Interest Rates
The Equilibrium Rate of Interest
In the Classical Theory of Interest Rates
Interest
Rate
Savings &
Investment
r
E

Q
E


Investment Savings
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5 - 15
The Classical Theory of Interest Rates
Limitations
Factors other than savings and investment that
affect interest rates are ignored. For example,
many financial institutions can create money
today by making loans to the public.
Today, economists recognize that income is
more important than interest rates in
determining the volume of savings.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
5 - 16
The Classical Theory of Interest Rates
In addition to the business sector, both
consumers and governments are also important
borrowers today.
Limitations continued
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The Liquidity Preference (Cash Balances)
Theory of Interest Rates
The liquidity preference (or cash balances) theory of
interest rates developed by Keynes (1936) is a short-
term theory that was developed for explaining near-
term changes in interest rates, and hence, is more
relevant for policymakers.

According to the theory, the rate of interest is the
payment to money (cash balances) holders for the use
of their scarce resource (liquidity), by those who
demand liquidity (i.e. money or cash balances).
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
5 - 18
It is a short-term approach to interest rate
determination unless modified because it assumes
that income remains stable.
In the longer term, interest rates are affected by
changes in the level of income and by inflationary
expectations.
Indeed, it is impossible to have a stable equilibrium
interest rate without also reaching an equilibrium
level of income, saving, and investment in the
economy.


The Liquidity Preference (Cash Balances)
Theory of Interest Rates
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5 - 19
Also, liquidity preference considers only the
supply and demand for the stock of money,
whereas business, consumer, and government
demands for credit clearly have an impact on
the cost of credit.
The Liquidity Preference (Cash Balances)
Theory of Interest Rates
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
5 - 20
The Liquidity Preference (Cash Balances)
Theory of Interest Rates
The demand for liquidity stems from:
the transactions motive - the purchase of goods
and services
the precautionary motive - to cope with future
emergencies and extraordinary expenses
the speculative motive - a rise in interest rates
results in lower bond prices
and depend on the level of national income,
business sales, and prices (but not interest rates).
So, demand due to and is fixed in the short term.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
5 - 21
The Liquidity Preference (Cash Balances)
Theory of Interest Rates
The Total Demand for Money or Cash Balances
in the Economy
Interest
Rate
Quantity of
Money / Cash
Balances
r

Total Demand
= + +
Q
+
: transactions
demand
: precautionary
demand
: speculative
demand
K
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5 - 22
The Liquidity Preference (Cash Balances)
Theory of Interest Rates
In modern economies, the money supply is
controlled, or at least closely regulated, by the
government.

The supply of money (cash balances) is often
assumed to be inelastic with respect to interest
rates, since government decisions concerning
the size of the money supply should
presumably be guided by public welfare.
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5 - 23
The Liquidity Preference (Cash Balances)
Theory of Interest Rates
The Equilibrium Interest Rate
In the Liquidity Preference Theory
Interest
Rate
Quantity of
Money / Cash
Balances
r
E

Total
Demand
Q
E
Money
Supply
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5 - 24
The Liquidity Preference (Cash Balances)
Theory of Interest Rates
Limitations
The liquidity preference theory is a short-term
approach. In the longer term, the assumption
that income remains stable does not hold.
Only the supply and demand for money is
considered. A more comprehensive view that
considers the supply and demand for credit by
all actors in the financial system - businesses,
households, and governments - is needed.
2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
5 - 25
The Loanable Funds Theory of Interest
The popular loanable funds theory argues that
the risk-free interest rate is determined by the
interplay of two forces:
the demand for credit (loanable funds) by
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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5 - 26
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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5 - 27
The Loanable Funds Theory of Interest
Total Demand for Loanable Funds (Credit)
Interest
Rate
Amount of
Loanable Funds
Total Demand = D
consumer
+
D
business
+
D
government
+
D
foreign

2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin
5 - 28
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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5 - 29
The Loanable Funds Theory of Interest
Creation of Credit by the Domestic Banking
System. Commercial banks and nonbank thrift
institutions offering payments accounts can
create credit by lending and investing their
excess reserves.
Foreign lending is sensitive to the spread
between domestic and foreign interest rates.
The Supply of Loanable Funds continued
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5 - 30
The Loanable Funds Theory of Interest
Total Supply of Loanable Funds (Credit)
Interest
Rate
Amount of
Loanable Funds
Total Supply
= domestic savings +
newly created money +
foreign lending
hoarding demand
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5 - 31
The Loanable Funds Theory of Interest
The Equilibrium Interest Rate
Interest
Rate
Amount of
Loanable Funds
r
E

Q
E


Demand
Supply
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5 - 32
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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5 - 33
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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5 - 34
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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5 - 35
The Rational Expectations Theory of Interest
The public forms rational and unbiased
expectations about the future demand and
supply of credit, and hence interest rates.
Interest
Rate
Amount of
Loanable Funds
r
E

Q
E


Expected Demand
Expected Supply
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5 - 36
The Rational Expectations Theory of Interest
If the money and capital markets are highly
efficient, then interest rates will always be very
near their equilibrium levels, and the optimal
forecast of next periods interest rate is the
current interest rate.
Interest rates will change only if entirely new
and unexpected information appears, and the
direction of change depends on the publics
current set of expectations.
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5 - 37
The Rational Expectations Theory of Interest
Limitations
At the moment, we do not know very much
about how the public forms its expectations.
The cost of gathering and analyzing
information relevant to the pricing of assets is
not always negligible, as assumed.
Not all interest rates and security prices appear
to display the kind of behavior implied by the
rational expectations theory.
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5 - 38
Nominal and Real Interest Rates
Nominal interest rate makes no allowance for
inflation.
Real interest rates is adjusted by subtracting
expected changes in the price level which
reflects true cost of borrowing.
Irving Fisher has given an equation to
calculate the real interest rate;
real int rate = nominal int rate inflation rate
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5 - 39
Example
What is the real interest rate if the nominal
interest rate is 8% and the expected inflation
rate is 10% over the course of the year?
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5 - 40
Chapter Review
Introduction
Functions of the Interest Rate in the Economy
The Classical Theory of Interest Rates
Savings by Households, Business Firms and
Governments
The Demand for Investment Funds
The Equilibrium Interest Rate
Limitations of the Classical Theory
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5 - 41
Chapter Review
The Liquidity Preference or Cash Balances
Theory of Interest Rates
The Demand for Liquidity
The Supply of Money (Cash Balances)
The Equilibrium Interest Rate
Limitations of the Liquidity Preference Theory
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5 - 42
Chapter Review
The Loanable Funds Theory of Interest
The Demand for Loanable Funds
The Supply of Loanable Funds
The Equilibrium Interest Rate
The Rational Expectations Theory of Interest