Chapter 2

Determination of Interest Rates

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Financial Markets and Institutions, 10e, Jeff Madura
Copyright ©2012by South-Western, a division of Thomson Learning. All rights reserved.
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Chapter Outline
 Loanable funds theory
 Economic forces that affect interest
rates
 Forecasting interest rates
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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
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Loanable Funds Theory

(cont’d)
 Household demand for loanable funds
 Households demand loanable funds to
finance
 Housingexpenditures
 Automobiles
 Household items
 There is an inverse relationship between
the interest rate and the quantity of
loanable funds demanded
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):
n
CFt
NPV  INV 
t 1 (

1  k ) t

 Projects with a positive NPV are accepted

 There is an inverse relationship between interest rates
and business demand for loanable funds

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Loanable Funds Theory

(cont’d)
 Government demand for loanable funds
 Governments demand funds when
planned expenditures are not covered by
incoming revenues
 Municipalitiesissue municipal bonds
 The federal government issues Treasury
securities and federal agency securities
 Government demand for loanable funds is
interest-inelastic
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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
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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
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Loanable Funds Theory

(cont’d)

Dh Db

Household Demand Business Demand

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Loanable Funds Theory

(cont’d)

Dg Dm

Federal Government Demand Municipal Government Demand

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Loanable Funds Theory

(cont’d)

Df

Foreign Demand
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Loanable Funds Theory

(cont’d)

DA

Aggregate Demand
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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
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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
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Loanable Funds Theory

(cont’d)
SA

Aggregate Supply
Loanable Funds Theory (cont’d)
 Equilibrium interest rate - algebraic
 The aggregate demand can be written as

DA  Dh  Db  Dg  Dm  Df
 The aggregate supply can be written as

S A  Sh  Sb  Sg  Sm  Sf

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Loanable Funds Theory

(cont’d)
SA

DA

Equilibrium Interest Rate - Graphic

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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
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Loanable Funds Theory

(cont’d)
SA

i2

DA2
DA

Impact of Economic Expansion

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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)
 Householdsand businesses borrow more to
purchase products before prices rise
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Loanable Funds Theory

(cont’d)
SA2 S
A

i2

i
DA2
DA

Impact of Expected Increase in Inflation

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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
Economic Forces That Affect
Interest Rates (cont’d)
 Fisher effect (cont’d)
 Fisher effect equation:

i  E (INF )  i R
 The difference between the nominal
interest rate and the expected inflation rate
is the real interest rate:

i R  i  E (INF )

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Economic Forces That Affect

Interest Rates (cont’d)
 Money supply
 If the Fed increases the money supply, the
supply of loanable funds increases
 Ifinflationary 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
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Economic Forces That Affect

Interest Rates (cont’d)
 Money supply (cont’d)
 September 11
 Firmscut 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
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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
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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
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Exhibit 2.11 Flow of Funds between the

Federal Government and the Private Sector
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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
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Forecasting Interest Rates

 Itis 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
Forecasting Interest Rates
(cont’d)
 Toforecast future interest rates, the net
demand for funds (ND) should be
forecast:

ND  DA  S A

 Dh  Db  Dg  Dm  Df 

 Sh  Sb  Sg  Sm S 
f

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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
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Exhibit
2.14
Framework
for
Forecastin
g Interest
Rates