CHAPTER 3

INTEREST RATE DETERMINATION

 Interest is the price paid for the use of others money over a period of time
 Borrowers must pay interest to secure scarce loanable funds from lender for an agreed-
upon period.
 The rate of interest is really a ratio of two quantities: –
 cost of borrowing funds
 the amount of money actually borrowed
 Interest rates send price signals to
 borrowers,
 lenders,
 savers, and
 investors.
higher interest rates generally bring forth a greater volume of savings and stimulate the lending
of funds.
Lower interest rate, on the other hand, tend to lower the flow of savings and reduce lending
activity.
The Theory of Interest Rates
1.The Classical theory of Interest Rates;
2. Liquidity preference theory interest rate;
3. The Loanable Funds theory of Interest Rates;
4. The Rational Expectations theory of Interest Rates.
1.The Classical theory of Interest Rates;
two forces
 supply of savings, derived mainly from households, business org. and government unit.
 demand capital for investment by the business sector, individuals and government units.

 positive relationship between interest rate and volume of saving. (+S & IR)
 negative relationship between demand of capital for investment and interest rate. (-C &
IR)

2. The Liquidity Preference Theory

 It is a short-run approach to interest rate determination because it assumes that
income remains stable.
 the public demands immediate money for three different purposes.
  transactions motive: the demand for money in order to purchase
goods and services.
 precautionary motive: To cover future unexpected expenses.
 Speculative motive: holding money to overcome uncertainty
about the declining security prices.
The total demand for money in the economy is simply the sum of transactions, precautionary,
and speculative demands.
 only two outlets for investor fund are considered or assumed-
 bonds and
 money (including bank deposits).
interest rates rise, the market value of bonds paying a fixed rate of interest will fall.
interest rate is falls; the bond price will increase i.e. (investors receive capital gain by holding
bond).
 short-run approach to interest rate determination because it assumes that
 income remains stable but in
 long run income is not stable
3. The Loanable Funds Theory
The two forces of supply & demand for loanable funds determine not only the volume of lending
& borrowing going in the economy, but also the rate of interest.
 risk-free interest rate is determined by the interplay of two forces:
 demand for loanable funds and
 the supply of loanable funds.
 The demand for loanable funds consists of:
 Credit demands from domestic businesses;
 Consumers;
 units of government and
 borrowing in the domestic market by foreigners. Like Foreign banks,
corporations, and foreign governments
 The supply of loanable funds stems from four sources:
 Domestic savings,
 Hoarding demand for money, either positive hoarding, which reduces
volume of loanable funds or negative hoarding/dishoarding, which
increases volume of loanable funds,
  Money creation by the banking system, and
 Lending in the domestic market by foreign individuals & institutions.
 The difference between the public's total demand for money and the money supply is
known as hoarding.
 Hoarding reduces the volume of loan able funds available in the financial markets.
 public's demand for money exceeds the supply, positive hoarding of money takes place
as individuals and businesses attempt to increase their money holdings.
 public's demand for money is less than the supply available, negative hoarding (also
called dishoarding) occurs.
 NB. positive hoarding, which reduces volume of loanable funds or negative
hoarding/dishoarding, which increases volume of loanable funds.

The Equilibrium Rate of Interest in The Loan able Funds Theory

a stable equilibrium interest rate will be characterized by:
1) Planned saving Planned investment (including both business and government investment)
across the whole economic system (i.e., equilibrium in the economy).
2) Money Supply= Money demand (i.e., equilibrium in the money market)
3) Quantity of loanable funds supplied= Quantity of loanable funds demanded (i.e.,
equilibrium in the loanable funds market).
The difference between foreign demand for loanable funds and the volume of loanable
funds supplied by foreigners to the domestic economy= The difference between current
exports form and imports into the domestic economy (i.e., equilibrium in the nation’s
balance of payments and the foreign currency markets).
4. The Rational Expectations Theory of Interest Rates
 Rational expectations theory developed on the bases that the interest rate increase or
decrease in the economy depends on expectation of rational investors about future based
on current information.
 The rational expectations theory also suggests that interest rates do not change
permanently from their current equilibrium levels unless new information appears.
 The Structure of Interest Rates
 The Base of Interest Rate: the interest rates on Treasury securities have served as
the benchmark interest or basis of interest rate throughout international financial
market.
 The Risk Premium: the investor faces by acquiring non treasury bill securities.
 Interest Rate = Base Interest Rate + Risk Premium