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Lesson Outline
2

Chapter 02
• Loanable funds theory

• Factors affecting interest rates

Determination of Interest Rates • Forecasting interest rates

Md. Kaysher Hamid

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Loanable Funds Theory Demand for Loanable Funds

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• This theory suggests that the market interest rate is determined by factors • Refers to the borrowing activities of households, businesses, and
controlling the supply of and demand for loanable funds. governments

• The theory is especially useful for explaining movements in the general

level of interest rates for a particular country

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Demand for Loanable Funds Demand for Loanable Funds

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 Household demand for loanable funds  Business demand for loanable funds

• To finance housing expenditures as well as • Depends on number of business projects to be

the purchase of automobiles and household implemented.
items.
• More demand at lower interest rates.
• Inverse relationship between the interest
rate and the quantity of loanable funds
demanded.

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Demand for Loanable Funds Demand for Loanable Funds

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 Government demand for loanable funds  Foreign demand for loanable funds

• Governments demand loanable funds when • A country’s demand for foreign funds
planned expenditures are not covered by depends on the interest rate differential

incoming revenues. between the two.

• The greater the differential, the greater the

• Government demand is said to be interest
demand for foreign funds.
inelastic: insensitive to interest rates.
• The quantity of U.S. loanable funds
• Expenditures and tax policies are independent
demanded by foreign governments will be
of the level of interest rates.
inversely related to U.S. interest rates.

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Demand for Loanable Funds Supply of Loanable Funds

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 Aggregate demand for loanable funds • Refers to funds provided to financial markets by savers.

• The sum of the quantities demanded by the separate sectors at any given • Households as a group are a net supplier of loanable funds, whereas
interest rate. governments and businesses are net demanders of loanable funds.

• Suppliers of loanable funds are willing to supply more funds if the interest
rate (reward for supplying funds) is higher, other things being equal.

• Supply-of-loanable-funds schedule (also called the supply curve) is upward

sloping

• Effects of BB - By affecting the supply of loanable funds, BB’s monetary

policy affects interest rates.

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Supply of Loanable Funds Equilibrium Interest Rate

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 Aggregate supply of funds  Aggregate Demand for funds (DA)
D A = Dh + Db + D g + Dm + D f
• The combination of all sector supply schedules
along with the supply of funds provided by the Dh = household demand for loanable funds
Db = business demand for loanable funds
BB’s monetary policy Dg = federal government demand for
loanable funds
• The quantity of loanable funds demanded is
Dm = municipal government demand for
normally expected to be more elastic, meaning loanable funds
Df = foreign demand for loanable funds
more sensitive to interest rates, than the
quantity of loanable funds supplied. In equilibrium,
DA = S A
 Aggregate Supply of funds (SA)
S A = Sh + Sb + Sg + Sm + Sf
Sh = household supply for loanable funds
Sb = business supply for loanable funds
Sg = federal government supply for
loanable funds
Sm = municipal government supply for
loanable funds
Sf = foreign supply for loanable funds

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Equilibrium Interest Rate Factors Affecting Interest Rates

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 Impact of economic growth on interest rates

• Economic growth puts upward pressure on interest rates by shifting

demand for loanable funds outward.

Impact of Increased Expansion by Firms Impact of an Economic Slowdown

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Factors Affecting Interest Rates Factors Affecting Interest Rates

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 Impact of inflation on interest rates  Impact of inflation on interest rates

• Puts upward pressure on interest rates by • Fisher proposed that nominal interest payments compensate savers in two
shifting supply of funds inward and ways.
demand for funds outward. o First, they compensate for a saver’s reduced purchasing power.

• New equilibrium interest rate is higher
because of these shifts in saving and
borrowing behavior
Md. Kaysher Hamid
o Second, they provide an additional premium to savers for forgoing
present consumption.
• Fisher effect: i = E(INF) + iR
where, i = nominal or quoted rate of interest
E(INF) = expected inflation rate
iR = real interest rate
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Factors Affecting Interest Rates Factors Affecting Interest Rates

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 Impact of Monetary Policy on Interest Rates  Impact of the Budget Deficit on Interest Rates

• When the BB reduces (increases) the money supply, it reduces • Crowding-out Effect: Given a certain amount of loanable funds supplied
(increases) the supply of loanable funds, putting upward (downward) to the market, excessive government demand for funds tends to “crowd
pressure on interest rates. out” the private demand for funds.

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Forecasting Interest Rates Forecasting Interest Rates

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• Net Demand for funds (ND) should be forecast: •

ND = DA – SA
ND = (Dh + Db + D,m + Dr) – (Sh + Sb + Sm + Sf)

• If the forecasted level of ND is positive or negative, then a disequilibrium will

exist temporarily.

• If ND is positive, the disequilibrium will be corrected by an upward adjustment

in interest rates; if ND is negative, the disequilibrium will be corrected by a
downward adjustment.

• The larger the forecasted magnitude of ND, the larger the adjustment in interest
rates.
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