2

Determination of Interest Rates

2003 South-Western/Thomson Learning

CHAPTER OBJECTIVES

Explain Loanable Funds Theory of Interest Rate Determination Identify Major Factors Affecting the Level of Interest Rates Explain How to Forecast Interest Rates

SECTORS OF THE ECONOMY

Household Sector--Usually a net supplier of loanable funds Business Sector Usually a net demander in growth periods Government Sectors- Borrow for capital projects and deficit spending Foreign SectorsNet supplier since early 1980s

Household Demand for Loanable Funds

Households demand loanable funds to finance housing, automobiles, household items These purchases result in installment debt. Installment debt increases with the level of income There is an inverse relationship between the interest rate and the quantity of loanable funds demanded

LOANABLE FUNDS THEORY: DEMAND FOR LOANABLE FUNDS

LOANABLE FUNDS THEORY: DEMAND FOR LOANABLE FUNDS

Business Demand for Loanable Funds

Businesses demand loanable funds to invest in assets Quantity of funds demanded depends on how many projects to be implemented. Businesses choose projects by calculating the projects Net Present Value

CFt NPV t ( 1 k ) t 0
If interest rates decrease, more projects will have a positive NPV. There is an inverse relationship between interest rates and the quantity of loanable funds demanded
Businesses will need a greater amount of financing Businesses will demand more loanable funds

LOANABLE FUNDS THEORY: DEMAND FOR LOANABLE FUNDS

Government Demand for Loanable Funds

Municipal (state and local) governments issue municipal bonds
Federal government and its agencies issue Treasury securities and federal agency securities.

LOANABLE FUNDS THEORY: DEMAND FOR Government Demand for Loanable Funds LOANABLE FUNDS
When planned expenditures exceed revenues from taxes, the government demands loanable funds Federal government expenditure and tax policies are independent of interest rates. Government demand for funds is interest-inelastic
Interest Rate

D
Quantity of Loanable Funds

Foreign Demand for Loanable Funds

A foreign countrys demand for U.S. funds is influenced by the differential between its interest rates and U.S. rates
The quantity of U.S. loanable funds demanded by foreign investors will be inversely related to U.S. interest rates

LOANABLE FUNDS THEORY: DEMAND FOR LOANABLE FUNDS

LOANABLE FUNDS THEORY: DEMAND FOR LOANABLE FUNDS

Aggregate Demand for Loanable Funds

The aggregate demand for loanable funds is the sum of the quantities demanded by the separate sectors The aggregate demand for loanable funds is inversely related to interest rates

DEMAND FOR LOANABLE FUNDS

Interest Rate

Quantity of Loanable Funds

SECTOR SUPPLY OF LOANABLE FUNDS

Households are major suppliers of loanable funds Businesses and governments may invest (loan) funds temporarily Foreign sector a net supplier of funds Variables other than interest rate changes causes a shift in the supply curve

Supply of Loanable Funds

Interest Rate

Quantity of Loanable Funds

LOANABLE FUNDS THEORY

Equilibrium Interest Rate

Aggregate Demand DA = Dh + Db + Dg + Dm + Df Aggregate Supply SA = S h + S b + S g + Sm + S f In equilibrium, DA = SA

GRAPHIC PRESENTATION

Interest Rates

Supply of Loanable Funds

Demand for Loanable Funds

Quantity of Loanable Funds

THE COST OF MONEY

oIn case of debt capital, cost of money refers to the interest rate. oIn case of equity capital, cost of money is the required return. This is the return expected by the shareholders to leave the share price unchanged.

FACTORS AFFECTING THE COST OF MONEY?

Production opportunities: More attractive production opportunity or technological progress shifts the demand curve right. Cost increases. Time preferences for consumption: If present consumption gets more priority than deferred consumption, then supply curve shifts left. Cost increases. Risk: Increased risk makes savings less attractive, supply curve shifts left. Risk and return are proportional. Increased risk leads to an upward shift of demand curve. Cost increases. (Figure: next slide) Expected inflation: If expected inflation increases supply curve shifts left as durable consumption increases and savers demand more return. Demand curve shifts right as demand for raw material and fixed assets increases. Cost increases. Economic Growth: As an impact of the increased expansion by businesses there should be outward shift in the demand curve and no obvious shift in supply curve.

EFFECTS OF INCREASED RISK ON COST OF MONEY: LOANABLE

i FUND THEORY S
1

S (Savings)

k1
k D1 D (Investment) Quantity of Loanable Fund

ECONOMIC FORCES THAT AFFECT INTEREST RATES

Inflation

The Fisher Effect: in=ir+E(Inflation)

Nominal Interest Rates = Sum of Real Rate plus Expected Rate of Inflation

If inflation is expected to increase

Households may reduce their savings to make purchases before prices rise. Supply shifts to the left, raising the equilibrium rate Also, households and businesses may borrow more to purchase goods before prices increase. Demand shifts outward, raising the equilibrium rate

ECONOMIC FORCES THAT AFFECT INTEREST RATES

Money Supply When the Fed increases the money supply, it increases supply of loanable funds. Places downward pressure on interest rates Government Budget Deficit Increase in deficit increases the quantity of loanable funds demanded. Demand schedule shifts outward, raising rates Government is willing to pay whatever is necessary to borrow funds, crowding out the private sector

ECONOMIC FORCES THAT AFFECT INTEREST RATES

Foreign Flows
In recent years there has been massive flows between countries Driven by large institutional investors seeking high returns

They invest where interest rates are high and currencies are not expected to weaken
These flows affect the supply of funds available in each country Investors seek the highest real after-tax, exchange rate adjusted rate of return around the world

FORECASTING INTEREST RATES

Attempts to forecast demand/supply shifts Forecast economic sector activity and impact upon demand/supply of loanable funds Forecast incremental effects on interest rates Forecasting interest rates has been difficult

SUMMARY: KEY FACTORS IMPACTING INTEREST RATES OVER TIME

Economic GrowthIncreased growth; increased demand for funds; interest rates increase Expected inflation--security prices fall; interest rates increase Government budgets
Deficitincrease borrowing; security prices fall, interest rates increase Surplusdecreased borrowing; security prices increase; interest rates decrease

Increased foreign supply of loanable funds security