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 3:  Interest  Rates  

I. Loanable  Funds  theory  
a. Market  interest  rates  are  controlled  by  supply  and  demand    
b. Components  of  demand  (Who  demand  funds?)  
i. Households  
ii. Businesses  
iii. Governments  –  federal  and  municipal  
iv. Foreign  entities  (govts,  households,  businesses)  
v. DA =   Dh + Db + Dg + Dm + D f  
c. Supply  
i. Again,  a  aggregation  of  savings  by  individuals,  governments  
(foreign  in  the  case  of  the  US),  and  corporations  
€ €
ii. The  Fed  also  plays  a  role  
iii. SA =   Sh + Sb + Sg + Sm + S f  
d. What  happens  to  interest  rates  when:  
i. SA > DA ?  
€ €ii. SA < DA ?  
iii. SA = DA ?  
e.€ Example  #1,  Comparative  statics:  
i. Suppose   SA = DA  and  the  market  interest  rate  is  5%.  What  

would  happen  to   SA ,   DA ,  and  interest  rates  if  a  foreign  

government  decided  to  no  longer  demand  any  US  securities?  
Show  it  graphically.  Now,  what  would  happen  if  a  global  

recession  decreased  the  supply  of  loanable  funds?  What  is  the  
graphic  € €
representation   of  this  if  the  impact  on  supply  was  2x  
larger  than  the  impact  on  demand  earlier?  
II. Economic  forces  and  interest  rates  
a. Economic  Growth  
i. Growth  =  upward  pressure  from  demand  shift  
ii. Decline  =  downward  pressure  from  demand  shift  
iii. Example  #2:­‐credit-­‐outstanding  
1. What  happened  to  the  quantity  of  loans  during  the  last  
recession?  Can  you  tell  if  it  was  supply  or  demand  
driven  from  this  graph?  
2. If  this  was  demand  driven,  what  should  have  happened  
to  interest  rates?  
3. If  this  was  supply-­‐drive,  what  should  have  happened  to  
interest  rates?­‐paper-­‐interest-­‐rate  
4. Show  a  comparative  statics  analysis.  
b. Inflation  
i. What  change  in  behavior  would  an  increase  in  expected  
inflation  bring  about?  
1. Spending  is  brought  forward/supply  of  savings  in  
decreased  –  this  can  also  show  up  as  increased  
2. Both  of  these  actions  lead  to  an  increase  in  interest  
ii. Example  #3:    
1. Based  on  this  graph  and  assuming  that  individuals  
assume  current  inflation  rates  are  the  best  predictor  of  
future  inflation  rates,  when  would  you  have  expected  
interest  rates  to  be  highest?­‐graph­‐year-­‐treasury-­‐rate  
c. Monetary  policy  (see  notes  from  week  #2)  
d. Budget  deficit  (increase  in  demand)  
i. Crowding  out  effect  
1. Is  the  the  gov’t  demand  curve  vertical?    
2. What  does  that  mean  for  other  sources  of  demand  
e. Foreign  flows  
i. Supply  and  demand  characteristics  vary  among  currencies  
based  on  inflation,  economic  growth,  size  and  scale  of  
economy,  etc  
III. Forecasting  Interest  Rates  
a. Calculate  Net  demand  
i. If  net  demand  in  positive,  interest  rates  will  rise  until  mkt  is  in  
ii. If  net  demand  is  negative,  interest  rates  will  decline  until  mkt  
is  in  equilibrium  
IV. What  causes  yields  to  vary?  
a. Credit  risk­‐and-­‐baa  
b. Liquidity  
c. Tax  status  
i. Tax  equivalent  yield  
1. Yield  (after-­‐tax)  =  yield  (before-­‐tax)*(1-­‐  tax  rate)  
d. Term  to  maturity  
i. Yield  Curve  
V. Estimate  the  appropriate  yield  
a. Use  the  components  above  to  “build”  the  appropriate  yield  for  a  
VI. Does  reality  match  theory?  
i. “They  find  that  liquidity  risk  is  priced  into  credit  spreads  and  
explains  a  significant  portion  of  observed  credit  spreads.  The  
size  of  the  liquidity  premium  is  determined  by  the  size  of  the  
bond  issuance,  the  yield  volatility,  and  the  age  of  the  bond.  
They  also  find  that  the  liquidity  risk  premium  is  time-­‐varying.”  
ii. “Despite  this  careful  setup  there  is  still  about  one-­‐third  of  the  
credit  spread  for  the  average  BBB-­‐rated  firm  that  is  not  
explained  by  Driessen's  model.  He  refers  to  this  missing  piece  
as  a  large  risk  premium  possibly  caused  by  a  tendency  for  
firms  to  default  in  waves.  This  is  a  risk  that  is  difficult  to  
eliminate  by  diversification  and  therefore  investors  could  
require  a  premium  to  be  willing  to  carry  it.”  
VII. More  about  the  term  structure  
a. Pure  Expectations  theory  
i. Term  structure  is  determined  solely  by  expectations  of  future  
interest  rates  
1. Impact  of  expected  increase  in  IR  on:  
a. short  term  supply  and  demand  
b. long  term  supply  and  demand  
2. Impact  of  expected  decrease  in  IR  on:  
a. short  term  supply  and  demand  
b. long  term  supply  and  demand  
b. Liquidity  preference  theory  
i. Short  term  securities  tend  to  be  more  liquid  
c. Segmented  market  theory  
i. Buyers  and  sellers  choose  securities  that  march  their  cash-­‐flow