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, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

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

a
Loanable Funds Theory
º G

   suggests that the
market interest rate is determined by the factors
that affect the supply of and demand for
loanable funds
ÿ Can be used to explain movements in the general
level of interest rates of a particular country
ÿ Can be used to explain why interest rates among debt
securities of a given country vary

è
Loanable Funds Theory (cont¶d)
º  ousehold demand for loanable funds
ÿ  ouseholds demand loanable funds to
finance
º  ousing expenditures
º Automobiles

º  ousehold items

ÿ There is an inverse relationship between the

interest rate and the quantity of loanable
funds demanded

D
Loanable Funds Theory (cont¶d)
º åusiness demand for loanable funds
ÿ åusinesses demand loanable funds to invest in fixed assets and
short-term assets
ÿ åusinesses evaluate projects using net present value (NPV):


M

  


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†
(|
 )

º Projects with a positive NPV are accepted

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

Î
Loanable Funds Theory (cont¶d)
º Ëovernment demand for loanable funds
ÿ Ëovernments demand funds when planned
expenditures are not covered by incoming
revenues
º Municipalities issue municipal bonds
º The federal government issues Treasury securities
and federal agency securities
ÿ Ëovernment demand for loanable funds is






¦
Loanable Funds Theory (cont¶d)
º Foreign Demand for loanable funds
ÿ Foreign demand for U.S. funds is influenced
by the interest rate differential between
countries
ÿ The quantity of U.S. loanable funds
demanded by foreign governments or firms is
inversely related to U.S. interest rates
ÿ The foreign demand schedule will shift in
response to economic conditions


Loanable Funds Theory (cont¶d)
º Aggregate demand for loanable funds
ÿ The sum of the quantities demanded by the
separate sectors at any given interest rate is
the aggregate demand for loanable funds

ù
Loanable Funds Theory (cont¶d)

Dh Db

 ousehold Demand åusiness Demand


Loanable Funds Theory (cont¶d)

Dg Dm

Federal Ëovernment Demand Municipal Ëovernment Demand

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Loanable Funds Theory (cont¶d)

Df

Foreign Demand

||
Loanable Funds Theory (cont¶d)

DA

Aggregate Demand

|a
Loanable Funds Theory (cont¶d)
º Supply of loanable funds
ÿ Funds are provided to financial markets by
º  ouseholds (net suppliers of funds)
º Ëovernment units and businesses (net borrowers
of funds)
ÿ Suppliers of loanable funds supply more
funds at higher interest rates

|è
Loanable Funds Theory (cont¶d)
º Supply of loanable funds (cont¶d)
ÿ Foreign households, governments, and corporations
supply funds by purchasing Treasury securities
º Foreign households have a high savings rate
ÿ The supply is influenced by monetary policy
implemented by the Federal Reserve System
º The Fed controls the amount of reserves held by depository
institutions
ÿ The supply curve can shift in response to economic
conditions
º  ouseholds would save more funds during a strong economy

|D
Loanable Funds Theory (cont¶d)

SA

Aggregate Supply

|Î
Loanable Funds Theory (cont¶d)
º Equilibrium interest rate - algebraic
ÿ The aggregate demand can be written as

 




2

ÿ The aggregate supply can be written as

  
 



2

|¦
Loanable Funds Theory (cont¶d)

SA

DA

Equilibrium Interest Rate - Ëraphic

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Economic Forces That Affect
Interest Rates
º Economic growth
ÿ Shifts the demand schedule outward (to the
right)
ÿ There is no obvious impact on the supply
schedule
º Supply could increase if income increases as a
result of the expansion
ÿ The combined effect is an increase in the
equilibrium interest rate

|ù
Loanable Funds Theory (cont¶d)

SA

i2

i
DA2
DA

Impact of Economic Expansion

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Economic Forces That Affect
Interest Rates (cont¶d)
º Inflation
ÿ Shifts the supply schedule inward (to the left)
º  ouseholds increase consumption now if inflation
is expected to increase
ÿ Shifts the demand schedule outward (to the
right)
º  ouseholds and businesses borrow more to
purchase products before prices rise

a
Loanable Funds Theory (cont¶d)

SA2 S
A

i2

i
DA2
DA

Impact of Expected Increase in Inflation

a|
Economic Forces That Affect
Interest Rates (cont¶d)
º Fisher effect
ÿ Nominal interest payments compensate
savers for:
º Reduced purchasing power
º A premium for forgoing present consumption

ÿ The relationship between interest rates and

expected inflation is often referred to as the
M
  

aa
Economic Forces That Affect
Interest Rates (cont¶d)
º Fisher effect (cont¶d)
ÿ Fisher effect equation:

 ( M )
á

ÿ The difference between the nominal interest rate

and the expected inflation rate is the 



:

 ´ ( )

aè
Economic Forces That Affect
Interest Rates (cont¶d)
º Money supply
ÿ If the Fed increases the money supply, the
supply of loanable funds increases
º If inflationary expectations are affected, the
demand for loanable funds may also increase
ÿ If the Fed reduces the money supply, the
supply of loanable funds decreases
ÿ During 200|, the Fed increased the growth of
the money supply several times

aD
Economic Forces That Affect
Interest Rates (cont¶d)
º Money supply (cont¶d)
ÿ September ||
º Firms cut back on expansion plans
º  ouseholds cut back on borrowing plans

º The demand of loanable funds declined

ÿ The weak economy in 200| 2002

º Reduced demand for loanable funds
º The Fed increased the money supply growth

º Interest rates reached very low levels

aÎ
Economic Forces That Affect
Interest Rates (cont¶d)
º åudget deficit
ÿ A high deficit means a high demand for loanable funds by the
government
º Shifts the demand schedule outward (to the right)
º Interest rates increase
ÿ The government may be willing to pay whatever is necessary to
borrow funds, but the private sector may not
º p
 
ÿ The supply schedule may shift outward if the government
creates more jobs by spending more funds than it collects from
the public

a¦
Economic Forces That Affect
Interest Rates (cont¶d)
º Foreign flows of funds
ÿ The interest rate for a currency is determined by the
demand for and supply of that currency
º Impacted by the economic forces that affect the equilibrium
interest rate in a given country, such as:
ÿ Economic growth
ÿ Inflation
ÿ Shifts in the flows of funds between countries cause
adjustments in the supply of funds available in each
country

a
Economic Forces That Affect
Interest Rates (cont¶d)
º Explaining the variation in interest rates over time
ÿ Late |
70s: high interest rates as a result of strong economy and
inflationary expectations
ÿ Early |
0s: recession led to a decline in interest rates
ÿ Late |
0s: interest rates increased in response to a strong
economy
ÿ Early |

0s: interest rates declined as a result of a weak
economy
ÿ |

: interest rates increased as economic growth increased
º Drifted lower for next several years despite strong economic growth,
partly due to the U.S. budget surplus

aù
Forecasting Interest Rates
º It is difficult to predict the precise change
in the interest rate due to a particular
event
ÿ åeing able to assess the direction of supply or
demand schedule shifts can help in
understanding why rates changed

a
Forecasting Interest Rates (cont¶d)

º To forecast future interest rates, the net

demand for funds (ND) should be forecast:

   

w 




2
w 




2

è
Forecasting Interest Rates (cont¶d)

º A positive disequilibrium in ND will be

corrected by an increase in interest rates
º A negative disequilibrium in ND will be
corrected by a decrease in interest rates

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