This action might not be possible to undo. Are you sure you want to continue?
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 authorities refer to the rate of interest as the price of credit. Interest rates send price signals to borrowers, lender, 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.
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 allocates the available supply of credit, generally providing loanable funds to those investment projects with the highest expected returns. It brings the supply of money into balance with the public’s demand for money. The interest rate serves as an important tool for government policy through its influence on the volume of savings and investment. To help uncover these rate-determining forces, we assume that there is one fundamental interest rate, known as the pure or risk-free rate of interest, which is a component of all interest rates. The closest real-world approximation to this pure rate of return is the market interest rate on government bonds.
The Classical Theory of Interest Rates
• The classical theory argues that the rate of interest is determined by two forces: I. the supply of savings, derived mainly from households, and II. the demand for investment capital, coming mainly from the business sector.
Household Savings • Current household savings equal the difference between current income and current consumption expenditures. • Individuals prefer current over future consumption, and the payment of interest is a reward for waiting. • Higher interest rates encourage the substitution of current saving for current consumption. 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.
to cope with future emergencies and extraordinary expenses • the speculative motive .. • According to the theory. is more relevant for policymakers.Income flows in the economy and the pacing of government spending programs are the dominant factors affecting government savings (budget surplus). and the comparison of that expected return with the anticipated returns of alternative projects. both consumers and governments are also important borrowers today. and hence. The Demand for Investment Funds • Gross business investment equals the sum of replacement investment and net investment. by those who demand liquidity (i. economists recognize that income is more important than interest rates in determining the volume of savings. So.. many financial institutions can “create” money today by making loans to the public. the rate of interest is the payment to money (cash balances) holders for the use of their scarce resource (liquidity). demand due to and is fixed in the short term. • One investment decision-making method involves the calculation of a project’s expected internal rate of return.a rise in interest rates results in lower bond prices • and depend on the level of national income. • In addition to the business sector. • The internal rate of return (r) equates the total cost of an investment project with the future net cash flows (NCF) expected from that project discounted back to their present values. business sales. 1 2 investment analysis rthe net present value (NPV) approach.the purchase of goods and services • the precautionary motive . Speculative Demand for Money or Cash Balances • . money or cash balances). • Today. • The demand for liquidity stems from: • the transactions motive . For example. The Liquidity Preference (Cash Balances) Theory of Interest Rates The liquidity preference (or cash balances) theory of interest rates is a short-term theory that was developed for explaining near-term changes in interest rates. • Cost of project = • • NCF n NCF1 NCF 2 . and prices (but not interest rates). 1 is n Another method of1 r 1 r Limitations • Factors other than savings and investment that affect interest rates are ignored. as well as with market interest rates.e.
and governments . • 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.is needed. In the longer term. A more comprehensive view that considers the supply and demand for credit by all actors in the financial system . or at least closely regulated. as well as foreign borrowers • the supply of loanable funds from domestic savings. consumers. dishoarding of money balances. as well as foreign lending • The Loanable Funds Theory of Interest The Demand for Loanable Funds • Consumer (household) demand is relatively inelastic with respect to the rate of interest. since government decisions concerning the size of the money supply should presumably be guided by public welfare. • The supply of money (cash balances) is often assumed to be inelastic with respect to interest rates. money creation by the banking system. households. Limitations • The liquidity preference theory is a short-term approach. • Only the supply and demand for money is considered.businesses. the assumption that income remains stable does not hold. • Domestic business demand increases as the rate of interest falls. by the government. .The Total Demand for Money or Cash Balances And the Equilibrium Rate of Interest In modern economies. the money supply is controlled. and governments.
• If the money and capital markets are highly efficient. • Interest rates will change only if entirely new and unexpected information appears. Foreign demand is sensitive to the spread between domestic and foreign interest rates. the supply of loanable funds available to others is increased. substitution. When individuals and businesses dispose of their excess cash holdings. then interest rates will always be very near their equilibrium levels. • Not all interest rates and security prices appear to display the kind of behavior implied by the rational expectations theory. and wealth effects is a relatively interest-inelastic supply of savings curve. and the direction of change depends on the public’s current set of expectations. Limitations • At the moment. money market. • The cost of gathering and analyzing information relevant to the pricing of assets is not always negligible. • Creation of Credit by the Domestic Banking System. • 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 • Interest rates will be stable only when the economy. 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. and the optimal forecast of next period’s interest rate is the current interest rate.• • Government demand does not depend significantly upon the level of interest rates. The Supply of Loanable Funds • Domestic Savings. and hence interest rates. • The public forms rational and unbiased expectations about the future demand and supply of credit. The net effect of income. 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. as assumed. and foreign currency markets are simultaneously in equilibrium. • . loanable funds market. we do not know very much about how the public forms its expectations. • Dishoarding of Money Balances.
This action might not be possible to undo. Are you sure you want to continue?
We've moved you to where you read on your other device.
Get the full title to continue listening from where you left off, or restart the preview.