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Chapte
r

The Determinants of Interest Rates:


Competing Ideas

Money and Capital Markets


Financial Institutions and Instruments in a Global Marketplace
Eighth Edition

Peter S. Rose

McGraw Hill / Irwin

Slides by Yee-Tien (Ted) Fu

5-2

Learning Objectives
To understand the important roles and
functions that interest rates perform within the
economy and the financial system.
To explore the most important ideas about the
determinants of interest rates and asset prices.
To identify the key forces that economists
believe set market interest rates and asset
prices into motion.
McGraw Hill / Irwin

2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5-3

Introduction
The acts of saving and lending, and borrowing
and investing, are significantly influenced by
and tied together by the interest rate.
The interest rate is the price a borrower must
pay to secure scarce loanable funds from a
lender for an agreed-upon time period.

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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5-4

Functions of the Interest Rate in the Economy


The interest rate helps guarantee that current
savings will flow into investment to promote
economic growth.
It rations the available supply of credit,
generally providing loanable funds to those
investment projects with the highest return.
It brings the supply of money into balance
with the publics demand for money.
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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5-5

Functions of the Interest Rate in the Economy


The interest rate serves as an important tool for
government policy through its influence on the
volume of savings and investment.

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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5-6

The Classical Theory of Interest Rates


The classical theory argues that the rate of
interest is determined by two forces:
the supply of savings, derived mainly from
households, and
the demand for investment capital, coming mainly
from the business sector.

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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5-7

The Classical Theory of Interest Rates


Household Savings
Current household savings equal the difference
between current income and current
consumption expenditures.
Individuals prefer current over future
consumption, and the payment of interest is a
reward for waiting.
Higher interest rates encourage the substitution
of current saving for current consumption.
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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5-8

The Classical Theory of Interest Rates


The Substitution Effect
Relating Savings and Interest Rates
Interest
Rate
r2
r1

S1
McGraw Hill / Irwin

S2

Current
Saving

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5-9

The Classical Theory of Interest Rates


Business and Government Savings
Most businesses hold savings balances in the
form of retained earnings, the amount of
which is determined principally by business
profits, and to a lesser extent, by interest rates.
Income flows in the economy and the pacing
of government spending programs are the
dominant factors affecting government savings
(budget surplus).
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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 10

The Classical Theory of Interest Rates


The Demand for Investment Funds
Gross business investment equals the sum of
replacement investment and net investment.
The investment decision-making process
typically involves the calculation of a projects
expected internal rate of return, and the
comparison of that expected return with the
anticipated returns of alternative projects, as
well as with market interest rates.
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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 11

The Classical Theory of Interest Rates


The Cost of Capital and the Investment Decision
Expected
Internal
Rates of
Return on
Alternative
Investment
Projects

A acceptable
15%

B acceptable
12%
C indifferent
10%
D
E
unprofitable 8%
unprofitable 7%

Cost of
Capital
Funds
= 10%

Dollar Cost of Investment Projects


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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 12

The Classical Theory of Interest Rates


The Investment Demand Schedule
In the Classical Theory of Interest Rates
Interest
Rate
r2

r1

I2
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I1

Investment
Spending

2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 13

The Classical Theory of Interest Rates


The Equilibrium Rate of Interest
In the Classical Theory of Interest Rates
Interest
Rate Investment Savings
rE

QE
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Savings &
Investment

2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 14

The Classical Theory of Interest Rates


Limitations
Factors other than savings and investment that
affect interest rates are ignored. For example,
many financial institutions can create money
today by making loans to the public.
Today, economists recognize that income is
more important than interest rates in
determining the volume of savings.
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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 15

The Classical Theory of Interest Rates


Limitations continued
In addition to the business sector, both
consumers and governments are also important
borrowers today.

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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 16

The Liquidity Preference (Cash Balances)


Theory of Interest Rates
The liquidity preference (or cash balances)
theory of interest rates is a short-term theory that
was developed for explaining near-term changes
in interest rates, and hence, is more relevant for
policymakers.
According to the theory, the rate of interest is the
payment to money (cash balances) holders for
the use of their scarce resource (liquidity), by
those who demand liquidity (i.e. money or cash
balances).
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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 17

The Liquidity Preference (Cash Balances)


Theory of Interest Rates
The demand for liquidity stems from:
the transactions motive - the purchase of goods
and services
the precautionary motive - to cope with future
emergencies and extraordinary expenses
the speculative motive - a rise in interest rates
results in lower bond prices

and depend on the level of national income,


business sales, and prices (but not interest rates).
So, demand due to and is fixed in the short term.

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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 18

The Liquidity Preference (Cash Balances)


Theory of Interest Rates
The Total Demand for Money or Cash Balances
in the Economy
Interest
Rate

Total Demand
= ++

K
McGraw Hill / Irwin

: transactions
demand
: precautionary
demand
: speculative
demand
Quantity of
Money / Cash
Balances

2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 19

The Liquidity Preference (Cash Balances)


Theory of Interest Rates
In modern economies, the money supply is
controlled, or at least closely regulated, by the
government.
The supply of money (cash balances) is often
assumed to be inelastic with respect to interest
rates, since government decisions concerning
the size of the money supply should
presumably be guided by public welfare.
McGraw Hill / Irwin

2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 20

The Liquidity Preference (Cash Balances)


Theory of Interest Rates
The Equilibrium Interest Rate
In the Liquidity Preference Theory
Interest
Rate

rE

Money
Supply

QE
McGraw Hill / Irwin

Total
Demand
Quantity of
Money / Cash
Balances

2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 21

The Liquidity Preference (Cash Balances)


Theory of Interest Rates
Limitations
The liquidity preference theory is a short-term
approach. In the longer term, the assumption
that income remains stable does not hold.
Only the supply and demand for money is
considered. A more comprehensive view that
considers the supply and demand for credit by
all actors in the financial system - businesses,
households, and governments - is needed.
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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 22

The Loanable Funds Theory of Interest


The popular loanable funds theory argues that
the risk-free interest rate is determined by the
interplay of two forces:
the demand for credit (loanable funds) by
domestic businesses, consumers, and
governments, as well as foreign borrowers
the supply of loanable funds from domestic
savings, dishoarding of money balances, money
creation by the banking system, as well as foreign
lending

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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 23

The Loanable Funds Theory of Interest


The Demand for Loanable Funds
Consumer (household) demand is relatively
inelastic with respect to the rate of interest.
Domestic business demand increases as the rate
of interest falls.
Government demand does not depend
significantly upon the level of interest rates.
Foreign demand is sensitive to the spread
between domestic and foreign interest rates.
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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 24

The Loanable Funds Theory of Interest


Total Demand for Loanable Funds (Credit)
Interest
Rate

Total Demand = Dconsumer +


Dbusiness +
Dgovernment +
Dforeign
Amount of
Loanable Funds

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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 25

The Loanable Funds Theory of Interest


The Supply of Loanable Funds
Domestic Savings. The net effect of income,
substitution, and wealth effects is a relatively
interest-inelastic supply of savings curve.
Dishoarding of Money Balances. When
individuals and businesses dispose of their
excess cash holdings, the supply of loanable
funds available to others is increased
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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 26

The Loanable Funds Theory of Interest


The Supply of Loanable Funds continued
Creation of Credit by the Domestic Banking
System. Commercial banks and nonbank thrift
institutions offering payments accounts can
create credit by lending and investing their
excess reserves.
Foreign lending is sensitive to the spread
between domestic and foreign interest rates.
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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 27

The Loanable Funds Theory of Interest


Total Supply of Loanable Funds (Credit)
Interest
Rate

Total Supply

= domestic savings +
newly created money +
foreign lending
hoarding demand

Amount of
Loanable Funds
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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 28

The Loanable Funds Theory of Interest


The Equilibrium Interest Rate
Interest
Rate
rE

Supply

Demand
QE

McGraw Hill / Irwin

Amount of
Loanable Funds

2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 29

The Loanable Funds Theory of Interest


At equilibrium:
Planned savings = planned investment across the
whole economic system
Money supply = money demand
Supply of loanable funds = demand for loanable
funds
Net foreign demand for loanable funds = net
exports

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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 30

The Loanable Funds Theory of Interest


Interest

rates will be stable only when the


economy, money market, loanable funds
market, and foreign currency markets are
simultaneously in equilibrium.

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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 31

The Rational Expectations Theory of Interest


The rational expectations theory builds on a
growing body of research evidence that the
money and capital markets are highly efficient
in digesting new information that affects
interest rates and security prices.

McGraw Hill / Irwin

2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 32

The Rational Expectations Theory of Interest


The public forms rational and unbiased
expectations about the future demand and
supply of credit, and hence interest rates.
Interest
Rate
rE

Expected Supply

Expected Demand
QE

McGraw Hill / Irwin

Amount of
Loanable Funds

2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 33

The Rational Expectations Theory of Interest


If the money and capital markets are highly
efficient, then interest rates will always be
very near their equilibrium levels, and the
optimal forecast of next periods interest rate is
the current interest rate.
Interest rates will change only if entirely new
and unexpected information appears, and the
direction of change depends on the publics
current set of expectations.
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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 34

The Rational Expectations Theory of Interest


Limitations
At the moment, we do not know very much
about how the public forms its expectations.
The cost of gathering and analyzing
information relevant to the pricing of assets is
not always negligible, as assumed.
Not all interest rates and security prices appear
to display the kind of behavior implied by the
rational expectations theory.
McGraw Hill / Irwin

2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 35

Money and Capital Markets in Cyberspace


Many websites explore topics related to
interest rates. See, for example,

http://www.lombard-st.co.uk/

http://www.rate.net/

http://www.globalfindata.com/

http://money.cnn.com/

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2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 36

Chapter Review
Introduction
Functions of the Interest Rate in the Economy
The Classical Theory of Interest Rates
Savings by Households, Business Firms and
Governments
The Demand for Investment Funds
The Equilibrium Interest Rate
Limitations of the Classical Theory

McGraw Hill / Irwin

2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 37

Chapter Review
The Liquidity Preference or Cash Balances
Theory of Interest Rates
The Demand for Liquidity
The Supply of Money (Cash Balances)
The Equilibrium Interest Rate
Limitations of the Liquidity Preference Theory

McGraw Hill / Irwin

2003 by The McGraw-Hill Companies, Inc. All rights reserved.

5 - 38

Chapter Review
The Loanable Funds Theory of Interest
The Demand for Loanable Funds
The Supply of Loanable Funds
The Equilibrium Interest Rate

The Rational Expectations Theory of Interest

McGraw Hill / Irwin

2003 by The McGraw-Hill Companies, Inc. All rights reserved.