Chapte

5
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.

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 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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 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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 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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 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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 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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 5-8

The Classical Theory of Interest Rates

The Substitution Effect

Relating Savings and Interest Rates
Interest
Rate
r2
r1

Current
S1 S2 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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 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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 5 - 11

The Classical Theory of Interest Rates

The Cost of Capital and the Investment Decision

Expected
Internal
A acceptable
Rates of 15%
Return on B acceptable
Alternative Cost of
Investment 12% C indifferent Capital
Projects Funds
10% D
E = 10%
unprofitable 8%
unprofitable 7%

Dollar Cost of Investment Projects

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 5 - 12

The Classical Theory of Interest Rates

The Investment Demand Schedule

In the Classical Theory of Interest Rates
Interest
Rate
r2
r1

Investment
I2 I1 Spending

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 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

Savings &
QE Investment

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 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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 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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 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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 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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 5 - 18

The Liquidity Preference (Cash Balances)

Theory of Interest Rates

The Total Demand for Money or Cash Balances

in the Economy
Interest
Rate : transactions
Total Demand demand
= ++ : precautionary
demand
r : speculative
+ demand

Quantity of
Money / Cash
K Q
Balances
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 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.

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 5 - 20

The Liquidity Preference (Cash Balances)

Theory of Interest Rates

The Equilibrium Interest Rate

In the Liquidity Preference Theory
Interest
Rate Money
Supply

rE Total
Demand

Quantity of
Money / Cash
QE Balances
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 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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 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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 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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 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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 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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 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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 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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 5 - 28

The Loanable Funds Theory of Interest

The Equilibrium Interest Rate

Interest
Rate Supply

rE
Demand
Amount of
QE Loanable Funds

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 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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 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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 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.

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 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 Expected Supply
Rate
rE
Expected Demand
Amount of
QE Loanable Funds

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 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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 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.
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 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/

McGraw Hill / Irwin 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

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 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

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 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.