PowerPoint Slides for:

Financial Markets
and Institutions
6th Edition
By Jeff Madura
Prepared by
David R. Durst
The University of Akron
CHAPTER
2
Determination of
Interest Rates
Chapter Objectives

 Explain Loanable Funds Theory of Interest

Rate Determination
 Identify Major Factors Affecting the Level of
Interest Rates
 Explain How to Forecast Interest Rates

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Relevance of Interest Rate Movements
 Changes in interest rates impact the real economy
 Investment spending
 Interest sensitive consumer spending such as housing
 Interest rate changes affect the values of all securities
 Security prices vary inversely with interest rates
 Varying interest rates impact retirement funds and retirement
income
 Interest rates changes impact the value of financial
institutions
 Managers of financial institutions closely monitor rates
 Interest rate risk is a major risk impacting financial
institutions
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Loanable Funds Theory of Interest Rate
Determination
 Theory of how the general level of interest
rates are determined
 Explains how economic and other factors
influence interest rate changes
 Interest rates determined by demand and
supply for loanable funds

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Loanable Funds Theory, cont.

 Demand = borrowers, issuers of securities,

deficit spending unit
 Supply = lenders, financial investors, buyers
of securities, surplus spending unit
 Assume economy divided into sectors
 Slope of demand/supply curves related to
elasticity or sensitivity of interest rates

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Sectors of the Economy

 Household Sector--Usually a net supplier of

loanable funds
 Business Sector—Usually a net demander in
growth periods
 Government Sectors
 States—Borrow for capital projects
 Federal—Borrow for capital projects and deficit
spending
 Foreign Sectors—Net supplier since early
1980’s
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Demand for Loanable Funds

 Sum of sector demand (quantity) at varying

levels of interest rates
 Sector cash receipts in period less than outlays
= borrower
 Quantity demanded inversely related to
interest rates
 Variables other than interest rate changes
cause shift in demand curve

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Demand for Loanable Funds

Interest
Rate

Quantity of Loanable Funds

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Loanable Funds Theory

Household Demand for Loanable Funds

 Households demand loanable funds to finance

housing, automobiles, household items
 These purchases result in installment debt.
Installment debt increases with the level of income
 There is an inverse relationship between the interest
rate and the quantity of loanable funds demanded
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Loanable Funds Theory

Business Demand for Loanable Funds

 Businesses demand loanable funds to invest in

assets
 Quantity of funds demanded depends on how
many projects to be implemented
 Businesses choose projects by calculating the project’s
Net Present Value
 Select all projects with +NPV’s
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Loanable Funds Theory

Business Demand for Loanable Funds

Net Present Value is calculated as follows:

n
NPV = –INV + 
t=1
CFt
(1 + k)t

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Loanable Funds Theory

Business Demand for Loanable Funds

 Projects with a positive NPV are accepted because

the present value of their benefits outweighs their
costs
 If interest rates decrease, more projects will have a
positive NPV
 Businesses will need a greater amount of financing
 Businesses will demand more loanable funds
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Loanable Funds Theory

Business Demand for Loanable Funds

 There is an inverse relationship between interest rates

and the quantity of loanable funds demanded
 The curve can shift in response to events that affect
business borrowing preferences
 Example: Economic conditions become more favorable
 Expected cash flows will increase > more positive NPV
projects > increased demand for loanable funds

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Loanable Funds Theory

Government Demand for Loanable Funds

 When planned expenditures exceed revenues from

taxes, the government demands loanable funds
 Municipal (state and local) governments issue
municipal bonds
 Federal government and its agencies issue
Treasury securities and federal agency securities.

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Loanable Funds Theory

Government Demand for Loanable Funds

 Federal government expenditure and tax policies
are independent of interest rates
 Government demand for funds is interest-inelastic

Interest
Rate

D
Quantity of Loanable Funds

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Loanable Funds Theory

Foreign Demand for Loanable Funds

 A foreign country’s demand for U.S. funds is
influenced by the differential between its interest
rates and U.S. rates
 The quantity of U.S. loanable funds demanded by
foreign investors will be inversely related to U.S.
interest rates

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Loanable Funds Theory

Aggregate Demand for Loanable Funds

 The aggregate demand for loanable funds is the

sum of the quantities demanded by the separate
sectors
 The aggregate demand for loanable funds is
inversely related to interest rates

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Sector Supply of Loanable Funds

 Households are major suppliers of loanable

funds
 Businesses and governments may invest
(loan) funds temporarily
 Foreign sector a net supplier of funds in last
twenty years
 Federal Reserve’s monetary policy impacts
supply of loanable funds

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Supply of Loanable Funds

 Sum of sector supply (quantity) at varying

levels of interest rates
 Sector cash receipts in period greater than
outlays—lender
 Quantity supplied directly related to interest
rates
 Variables other than interest rate changes
causes a shift in the supply curve

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Interest
Rate S

Quantity of Loanable Funds

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Loanable Funds Theory

 Equilibrium Interest Rate

 Aggregate Demand
DA = Dh + Db + Dg + Dm + Df

 Aggregate Supply
SA = Sh + Sb + Sg + Sm + Sf

In equilibrium, DA = SA

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Graphic Presentation

Interest Supply of
Rates Loanable Funds

Demand for
Loanable Funds

Quantity of Loanable Funds

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Loanable Funds Theory

 Graphic Presentation
 When a disequilibrium situation exists, market
forces should cause an adjustment in interest
rates until equilibrium is achieved
 Example: interest rate above equilibrium
 Surplus of loanable funds
 Rate falls
 Quantity supplied reduced, quantity demanded
increases until equilibrium

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General Equilibrium Interest Rate

 Means of explaining how economic factors

affect interest rate levels
 Interest rate level where quantity of aggregate
loanable funds demanded = supply
 Surplus and shortage conditions
 Surplus- Quantity demanded < quantity supplied
followed by market interest rate decreases
 ShortageGovernment interest rate ceilings below
market interest rates
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Interest Rate Changes

 + Directly related to level of economic

activity or growth rate of economic activity
 + Directly related to expected inflation
 – Inversely related to rates of money supply
changes

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Economic Forces That Affect Interest
Rates
 Economic Growth
 Expected impact is an outward shift in the demand
schedule without obvious shift in supply
 New technological applications with +NPV’s
 Result is an increase in the equilibrium interest
rate

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Economic Forces That Affect Interest
Rates: The Fisher Effect
 Lenders want to be compensated for expected
loss of purchasing power (inflation) when they
lend
 Nominal Interest Rates = Sum of real rate plus
expected rate of inflation, in = E(I) + i r
 Expected Real Rate (ex ante) = expected
increase in purchasing power in period
 Realized Real Rate (ex post) = nominal rates
less actual rate of inflation in period
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Economic Forces That Affect Interest
Rates
 Inflation
 The Fisher Effect
 Nominal Interest Rates = Sum of Real Rate plus
Expected Rate of Inflation

in = ir + E(I)

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Figure 2.12 here
20
Annualized
Real
Interest Rate
15 Annualized
Inflation

Annualized
10 T-Bill
Rate

-5
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
Year

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Economic Forces That Affect Interest
Rates
 Inflation
 If inflation is expected to increase
 Households may reduce their savings to make purchases
before prices rise
 Supply shifts to the left, raising the equilibrium rate
 Also, households and businesses may borrow more to
purchase goods before prices increase
 Demand shifts outward, raising the equilibrium rate

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Economic Forces That Affect Interest
Rates

 Money Supply
 When the Fed increases the money supply, it
increases supply of loanable funds
 Places downward pressure on interest rates

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Economic Forces That Affect Interest
Rates
 Federal Government Budget Deficit
 Increase in deficit increases the quantity of
loanable funds demanded
 Demand schedule shifts outward, raising rates
 Government is willing to pay whatever is
necessary to borrow funds, “crowding out” the
private sector

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Economic Forces That Affect Interest
Rates
 Foreign Flows
 In recent years there has been massive flows
between countries
 Driven by large institutional investors seeking
high returns
 They invest where interest rates are high and
currencies are not expected to weaken
 These flows affect the supply of funds available in
each country
 Investors seek the highest real after-tax, exchange
rate adjusted rate of return around the world
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Forecasting Interest Rates

 Attempts to forecast demand/supply shifts

 Forecast economic sector activity and impact
upon demand/supply of loanable funds
 Forecast incremental effects on interest rates
 Forecasting interest rates has been difficult

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Summary: Key Factors Impacting
Interest Rates Over Time
 Economic Growth—Increased growth; increased
demand for funds; interest rates increase
 Expected inflation--security prices fall; interest rates
increase
 Government budgets
 Deficit—increase borrowing; security prices fall, interest
rates increase
 Surplus—decreased borrowing; security prices increase;
interest rates decrease
 Increased foreign supply of loanable funds—security
prices increase; interest rates decrease
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