MONEY AND BANKING

Tran Thi Minh Tram

Email: tramttm@ftu.edu.vn

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 Chapter 3.2
The behavior of
interest rate

Assigned reading: chapter 5

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 LEARNING OBJECTIVES
• After studying this chapter you should be
able to
1. Describe how nominal interest rates are
determined
2. Outline the factors that cause interest rates to
change

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 Content

CHANGES IN EQUILIBRIUM INTEREST RATE

LOANABLE FUNDS APPROACH S D curve

BOND MARKET APPROACH P vs Q

LIQUIDITY PREFERENCE FRAMEWORK Bond vs Money

FACTORS THAT AFFECT INTEREST RATE

FORCASTING INTEREST RATE

INTEREST RATE RISK

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 LOANABLE FUNDS APPROACH
• Loanable funds theory suggests that the market
interest rate is determined by the factors that affect
the supply of and demand for loanable funds.
• The loanable funds approach is most useful when
looking at the flow of funds between domestic and
foreign financial markets.
• Can be used to explain:
– movements in the general level of interest rates of a
particular country
– why interest rates among debt securities of a given
country vary

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remind elastic

Household demand
• Household demand for loanable funds
– Households demand loanable funds to finance
✓Housing expenditures
✓Automobiles
✓Household items
– There is an inverse relationship between the
interest rate and the quantity of loanable funds
demanded

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Household demand

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 Business demand
• Business demand for loanable funds
– Businesses demand loanable funds to invest in
fixed assets and short-term assets
– Businesses evaluate projects using net present
value (NPV):
✓Projects with a positive NPV are accepted
• There is an inverse relationship between
interest rates and business demand for
loanable funds
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Business demand

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 Government demand
• Government demand for loanable funds
– Governments demand funds when planned
expenditures are not covered by incoming
revenues
✓Municipalities issue municipal bonds
✓The federal government issues Treasury securities and
federal agency securities
• Government demand for loanable funds is
interest-inelastic

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Government demand
Instead of raising the tax, Gov. will issue bonds to raise fund.
Treasury (kho bac) response for controlling Gov finance.

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 Foreign demand
• Foreign Demand for loanable funds
– Foreign demand for domestic funds is influenced
by the interest rate differential between countries
(the greater the differential, the greater the
demand).
– The quantity of domestic loanable funds
demanded by foreign governments or firms is
inversely related to domestic interest rates
– The foreign demand schedule will shift in
response to economic conditions

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Foreign demand

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 Aggregate demand
• Aggregate demand for loanable funds
– The sum of the quantities demanded by the
separate sectors at any given interest rate is the
aggregate demand for loanable funds

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Aggregate demand

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Aggregate demand

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 Supply of loanable funds
Vertical curve

• Funds are provided to financial markets by

– Households (net suppliers of funds)
– Government units and businesses (net borrowers of funds)
• Suppliers of loanable funds supply more funds at
higher interest rates
• Effects of the Central bank - By affecting the supply of
loanable funds, the Central bank’s monetary policy
affects interest rates.
• Aggregate supply of funds –Is the combination of all
sector supply schedules along with the supply of funds
provided by the Central bank’s monetary policy.
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Aggregate supply

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 Loanable fund theory
• Equilibrium interest rate – algebraic
– The aggregate demand can be written as
• DA = Dh + Db + Dg + Dm + Df
– The aggregate supply can be written as
• SA = Sh +Sb + Sg + Sm +Sf

• In which:
Dh/Sh = household demand/supply for loanable funds
Db/Sb = business demand/supply for loanable funds
Dg/Sg = federal government demand/supply for loanable funds
Dm/Sm = municipal government demand/supply for loanable funds
Df/Sf = foreign demand/supply for loanable funds

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Loanable fund theory

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 BOND MARKET APPROACH
• An alternative theory to explain for changes in
equilibrium of interest rates
• Determines the equilibrium interest rate in terms
of the supply of and demand for bond
• Most useful when considering how the factors
affecting the demand and supply for bonds affect
the interest rate
• Based on asset demand theory/ portfolio theory
– Theories to study about determinants of asset
demand

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Determinants of asset demand
• Facing the question of whether to buy and
hold an asset or whether to buy one asset
rather than another, an individual must
consider what factors?
Asset - own by someone + may bring about future value

How to build an investment portfolio?

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How to build an investment portfolio?
• Suppose you have the opportunity to choose an
investment on which you expect a rate of return of
10% but on which you believe there is a significant
chance of a return of -5%.
• Would you choose that investment over an investment
where you expect a return of 5% and do not believe
there is a chance of a negative return?
• Would your answer be different if you had $1,000 in
investments than if you had $1,000,000?
• Would your answer be different if you were 20 years
old than if you were 60 years old?

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 Determinants of asset demand
1. Wealth: the total resources owned by the individual,
including all assets
2. Expected return: (the return expected over the next
period) on one asset relative to alternative assets
3. Risk: (the degree of uncertainty associated with the
return) on one asset relative to alternative assets
4. Liquidity: (the ease and speed with which an asset
can be turned into cash) relative to alternative assets
5. The cost of acquiring information: about the
investment compared with the cost of acquiring
information about other investments
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Determinants of asset demand

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Determinants of asset demand

Data for the period from 1926 to 2009 in US on four

financial assets that are widely owned by investors

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Equilibrium in markets for bonds

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Changes in Equilibrium Interest Rates
• Shifts in the Demand for Bonds
1. Wealth
2. Expected returns on bonds relative to alternative
assets
3. Risk of bonds relative to alternative assets
4. Liquidity of bonds relative to alternative assets
5. Information cost relative to alternative assets
• Shifts in the Supply of Bonds
1. Expected profitability of investment opportunities
2. Expected inflation => issuers need to pay less interest
3. Government budget deficits
Normally, demand will change after supply => in business cycle expansion, supply curve will shift to
the right further than demand curve. 28
Shifts in demand curve for bonds

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Shifts in supply curve for bonds

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HOW i IS DETERMINED?
2 APPROACHES

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Loanable fund theory vs bond market
theory

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Loanable fund theory vs bond market
theory

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LIQUIDITY PREFERENCE FRAMEWORK
• The Liquidity Preference Framework determines
the equilibrium interest rate in terms of the
supply of and demand for money. ppl normally prefer liquidity
• Key assumption: people use two main categories
of assets to store their wealth - money and
bonds.
• Total wealth in the economy:
BS + MS = BD + MD
• Whereas:
– BS : bonds supplied; MS : money supplied
– BD : bonds demanded; MD : money demanded

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 Liquidity preference framework
Price bond high => i ?

• Rewrite the equation:

BS - BD = MD - MS
• If the market for money is in equilibrium, the
bond market is also in equilibrium
• The bond supply and demand framework is
easier to use when analysing the effects from
changes in expected inflation, whereas the
liquidity preference framework provides a
simpler analysis of the effects from changes in
income, the price level, and the supply of money.
Xac dinh diem can bang tren thi truong trai phieu khi xac dinh duoc diem can bang tren thi
truong tien te
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Equilibrium in the market for money

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Changes in Equilibrium Interest Rates
• Shifts in the Demand for Money
1. Income -> store of value, ability to carry
transactions
2. The price level -> medium of exchange/purchasing
power
• Shifts in the Supply of Money
1. Money supplied by the Central bank

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 Increase the
money supply
just has
temporary affect

Liquidity affect > Income + Price level +

Inflation => i fall

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FACTORS THAT AFFECT INTEREST RATE
• Economic growth
• Inflation
• Money supply/ Monetary policy
• Budget deficit
• Foreign flows of funds

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 Factors that affect interest rate
• Economic growth
– Puts upward pressure on interest rates by shifting
the demand schedule outward (to the right)
– There is no obvious impact on the supply schedule
✓Supply could increase if income increases as a result of
the expansion
– The combined effect is an increase in the
equilibrium interest rate

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Factors that affect interest rate

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Factors that affect interest rate

Impact of an Economic Slowdown

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 Factors that affect interest rate
• Inflation
– Shifts the supply schedule inward (to the left)
✓Households increase consumption now if inflation is
expected to increase
– Shifts the demand schedule outward (to the right)
✓Households and businesses borrow more to purchase
products before prices rise

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 Factors that affect interest rate
• Fisher effect
– Nominal interest payments compensate savers for:
✓Reduced purchasing power
✓A premium for forgoing present consumption
– The relationship between interest rates and
expected inflation is often referred to as the Fisher
effect
– Fisher effect states that the nominal interest rate
rises or falls point-for-point with changes in the
expected inflation rate.

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Factors that affect interest rate

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 Factors that affect interest rate
• Money supply/ Monetary policy
– If the Fed increases the money supply, the supply
of loanable funds increases
✓If inflationary expectations are affected, the demand
for loanable funds may also increase
– If the Fed reduces the money supply, the supply of
loanable funds decreases

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 Factors that affect interest rate
• Budget deficit
– A high deficit means a high demand for loanable funds
by the government
✓Shifts the demand schedule outward (to the right)
✓Interest rates increase
– The government may be willing to pay whatever is
necessary to borrow funds, but the private sector may
not
✓Crowding-out effect
– The supply schedule may shift outward if the
government creates more jobs by spending more
funds than it collects from the public

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 Factors that affect interest rate
• Foreign flows of funds
– The interest rate for a currency is determined by
the demand for and supply of that currency
✓Impacted by the economic forces that affect the
equilibrium interest rate in a given country, such as:
– Economic growth
– Inflation
– Shifts in the flows of funds between countries
cause adjustments in the supply of funds available
in each country

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Factors that affect interest rate

Demand and Supply Curves for Loanable Funds

Denominated in U.S. Dollars and Brazilian Real 51
 Summary of factors that affect
interest rates
1. Economic conditions are the primary forces behind
a change in the supply of savings provided by
households or a change in the demand for funds by
households, businesses, or the government.
2. The demand for funds in a country is indirectly
affected by its monetary and fiscal policies because
these policies influence economic growth and
inflation, which in turn affect business demand for
funds.
• Fiscal policy determines the budget deficit and therefore
determines the government demand for funds.

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 FORECASTING INTEREST RATE
• It is difficult to predict the precise change in
the interest rate due to a particular event
– Being able to assess the direction of supply or
demand schedule shifts can help in understanding
why rates changed

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 Forecasting interest rate
• To forecast future interest rates, the net
demand for funds (ND) should be forecast:
– The aggregate demand
• DA = Dh + Db + Dg + Dm + Df
– The aggregate supply
• SA = Sh +Sb + Sg + Sm +Sf
– ND = DA – SA

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 Forecasting interest rate
• A positive disequilibrium in ND will be
corrected by an increase in interest rates
• A negative disequilibrium in ND will be
corrected by a decrease in interest rates

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Framework for forecasting interest rates

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 INTEREST RATE RISK
• Interest-rate risk: The risk that the price of a
financial asset will fluctuate in response to
changes in market interest rates.
• Prices and returns for long-term bonds are
more volatile than those for shorter-term
bonds.
• There is no interest-rate risk for any bond
whose time to maturity matches the holding
period.

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 Interest rate risk
Maturity and the volatility of bond returns

• Are all bonds equally subject to interest-rate risk?

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 Interest rate risk
Maturity and the volatility of bond returns

Key Findings from Table 2

1. Only bond whose return = yield is one with maturity = holding period
2. For bonds with maturity > holding period, i  P implying capital loss
3. Longer is maturity, greater is % price change associated with interest rate
change
4. Longer is maturity, more return changes with change in interest rate
5. Bond with high initial interest rate can still have negative return if i 
Conclusion from Table 2 Analysis
1. Prices and returns more volatile for long-term bonds because have higher
interest-rate risk
2. No interest-rate risk for any bond whose maturity equals holding period

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 Summary
• The theory of portfolio choice tells us about the
determinants of asset demand.
• The supply and demand analysis for bonds provides one
theory of how interest rates are determined.
• An alternative theory of how interest rates are determined
is provided by the liquidity preference framework, which
analyzes the supply of and demand for money.
• There are four possible effects of an increase in the money
supply on interest rates.
• The loanable funds model and the international capital
market is used to analyze the international capital market.

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 ASSIGNMENT OF CHAPTER 2
1. SELF-TEST
2. REVIEW QUESTIONS
3. PROBLEMS

➢ DO IT BY YOURSELF FIRST
➢ ASK IN LATER CLASS IF YOU COULD NOT FINISH

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 PREPARE FOR CHAPTER 3
1. Read documents
Business cycle recession
S luon dich D
Bond price

Quantity

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