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DETERMINANTS OF INTEREST
RATES
CLASS MODE REVISION

Completed

EXAM WEEK 2

FILES

NOMINAL INTEREST RATES

What are nominal interest rates?

Nominal interest rates are interest rates is commonly observed in a

financial market

Nominal interest rates affect? 2

The price or value of securities being traded at the money or capital

market

It also affect spot and forward currency exchange

When is nominal interest rates use?

It is used in determining the present fair value and for the price of the
securities

2 types of component?

Opportunity cost

Adjustments for individual security characteristics

LOANABLE FUNDS THEORY

DETERMINANTS OF INTEREST RATES 1

 What is the deal with loanable funds theory?

Loanable funds theory explains interest rates and interest rates movement

It also emphasizes that equilibrium interest rates is actually the result of

the demand and supply of loanable funds

What is the difference between supply of loanable funds and demand for
loanable funds?

SUPPLY OF LOANABLE FUNDS = term used for the funds being supplied
by net fund suppliers

DEMAND FOR LOANABLE FUNDS = term used for the funds being
demanded by fund users

Who are the suppliers in the loanable funds framework?

The suppliers in the loanable funds framework are the financial market
participants

Who are the demanders of fund based on the the framework?

Consumers

Business

Government

Foreign market participants

SUPPLY OF LOANABLE FUNDS

In general, the quantity of loanable funds supplied increase as?

The quantity of loanable funds supplied increased as the interest rates

also increase

Explain figure 2.2 both for demand and supply of loanable funds

DETERMINANTS OF INTEREST RATES 2

 📌 With all the other things being constant, the higher the supply when
interest rates are high. For demand, the higher the demand as the
rates decrease since the cost of borrowing is less

Who is the largest supplier of loanable funds in the US in 2010? Why do they
supply funds?

Households are the largest supplier of loanable funds in the US especially

if they have excess income or if they just want to reallocate their asset
portfolio holdings

What is the deal if the total wealth of the consumer increase?

If the total wealth of the consumer increase hence the total funds
being supplied also increases

What are the factors or basis of a household in supplying funds? 4

Total wealth

Interest rates

Risks of the securities = the higher the risk in the securities, the lower
the possibility that they will invest

DETERMINANTS OF INTEREST RATES 3

 Immediate spending needs

In a business sector, what affects their overall supply of funds? 3

Risk in the securities

Interest rates

The investment needs of the business in the future

Do governments also supply funds?

Governments also supply funds. They actually generate more cash flows
that their budget.

What do governments do if their is a financial crisis?

If their is a financial crisis, the government actually supply more funds

to the business and consumers to help the overcome the recession

DEMAND FOR LOANABLE FUNDS

In general, the quantity of loanable funds demand is higher?

If the quantity of loanable funds demand is higher, interest rates decrease

Do households even though they are net suppliers also borrows funds from
markets?

Yes household still borrow even though they are are net suppliers.

The demand for loanable funds by household actively reflects?

House financing needs (mortgage)

Durable goods (appliances, cars)

Non-durable goods Education)

What is the deal with businesses whose interest rates are higher?

Businesses whose interest rates are higher they prefer to finance

investments with internally generated funds such as retained earnings
than borrowing funds

In a business setting when is the demand for loan funds greater?

DETERMINANTS OF INTEREST RATES 4

 The demand for loan funds are greater if the there is greater number of
projects available to the businesses or the overall economic conditions is
better

What do state and local governments often issue? For what purpose?

State and local governments often issue debt issue to finance temporary
imbalances between operating revenues (taxes) and budget expenditures

What can higher interest rates cause to state and local governments?

Higher interest rates can cause state and local governments to postponed
borrowings thus capital expenditures

What is the deal with foreign borrowers?

Foreign borrowers Business, Household, Government) still participate in

the US Markets since they tend to find the cheapest source of dollar

Most foreign borrowers actually came from:

BUSINESS SECTOR

EQUILIBRIUM INTEREST RATE

What is the aggregate supply of loanable fund? How is it related to interest
rates?

The aggregate supply of loanable fund is the total sum of the quantity
funds supplied by the separate fund supplying sectors

Positively related to interest rates

What is the aggregate demand for loanable funds? How is it related to

interest rates?

Aggregate demand for loanable funds is the total sum of the quantity
demanded by the separate fund demanding sectors

Inversely related to interest rates

Explain Figure 2.3

Equilibrium interest rate is the rate that equates that aggregate supply of
loanable fund and aggregate demand of loanable fund

DETERMINANTS OF INTEREST RATES 5

 There are some cases wherein the interest rate is higher than the
equilibrium interest due to having a surplus of funds. Hence, the suppliers
increase the interest rate to a rate that they are willing to offer for the
demanders to absorb the surplus of funds

There are also some instances wherein the interest rate is higher than the
equilibrium interest rate which is due to shortage of funds which resulted
to some demanders not able to have access to funds which will later on
resulted for some demanders to exit the market. On the other hand, this is
an opportunity for more suppliers to enter the market.

DETERMINANTS OF HOUSEHOLD SAVINGS

What are the determinants of household savings? 5

Interest rates and tax policy

Income and wealth

DETERMINANTS OF INTEREST RATES 6

 Attitudes about saving versus borrowing

Credit availability

Job security and belief in soundness of entitlements

DETERMINANTS OF FOREIGN FUNDS INVESTED IN

THE US
What are the determinants of foreign funds invested in the US? FRES

Foreign central bank investment in US

Relative interest rates and returns on global investments

Expected exchange rate changes

Safe haven status of U.S Investments

FACTORS THAT CAUSE SUPPLY AND DEMAND

CURVES TO SHIFT
Wealth & Income

EFFECT IN SUPPLY Increase

EFFECT IN DEMAND N/A

RESULT Lower interest rates

Risk

EFFECT IN SUPPLY Decrease

EFFECT IN DEMAND Decrease

RESULT Higher interest rates

Near term spending needs

EFFECT IN SUPPLY Decrease

EFFECT IN DEMAND N/A

RESULT Higher interest rates

Monetary expansion

DETERMINANTS OF INTEREST RATES 7

 EFFECT IN SUPPLY Increase

EFFECT IN DEMAND N/A

RESULT Lower interest rates

Economic growth

EFFECT IN SUPPLY Increase

EFFECT IN DEMAND Increase

RESULT Indeterminate interest rates but as the growth increase rapily,

interest rates also rise

Utility derived from assets

EFFECT IN SUPPLY Decrease

EFFECT IN DEMAND Increase

RESULT Higher interest rates

Restrictive covenants

EFFECT IN SUPPLY Increase

EFFECT IN DEMAND Decrease

RESULT Lower Interest Rates

Tax Increase

EFFECT IN SUPPLY Decrease

EFFECT IN DEMAND Increase

RESULT Higher interest rates

Currency Appreciation

EFFECT IN SUPPLY Increase

EFFECT IN DEMAND N/A

RESULT Lower Interest Rates

Expected Inflation

EFFECT IN SUPPLY Decrease

DETERMINANTS OF INTEREST RATES 8

 EFFECT IN DEMAND Increase

RESULT Higher Interest Rates

DETERMINANTS OF INTEREST RATES 9