Chapter 2

Determination of Interest Rates

Financial Markets and Institutions, 7e, Jeff Madura

Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

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Chapter Outline
 Loanable funds theory
 Economic forces that affect interest rates
 Forecasting interest rates

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Loanable Funds Theory
 Loanable funds theory suggests that the
market interest rate is determined by the factors
that affect the supply of and demand for
loanable funds
 Can be used to explain movements in the general
level of interest rates of a particular country
 Can be used to explain why interest rates among debt
securities of a given country vary

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Loanable Funds Theory (cont’d)
 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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Loanable Funds Theory (cont’d)
 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):
n
CFt
NPV  INV 
t 1 (1 
k ) t

 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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Loanable Funds Theory (cont’d)
 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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Loanable Funds Theory (cont’d)
 Foreign Demand for loanable funds
 Foreign demand for U.S. funds is influenced
by the interest rate differential between
countries
 The quantity of U.S. loanable funds
demanded by foreign governments or firms is
inversely related to U.S. interest rates
 The foreign demand schedule will shift in
response to economic conditions

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Loanable Funds Theory (cont’d)
 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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Loanable Funds Theory (cont’d)

Dh Db

Household Demand Business Demand

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Loanable Funds Theory (cont’d)

Dg Dm

Federal Government Demand Municipal Government Demand

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Loanable Funds Theory (cont’d)

Df

Foreign Demand

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Loanable Funds Theory (cont’d)

DA

Aggregate Demand

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Loanable Funds Theory (cont’d)
 Supply of loanable funds
 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

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Loanable Funds Theory (cont’d)
 Supply of loanable funds (cont’d)
 Foreign households, governments, and corporations
supply funds by purchasing Treasury securities
 Foreign households have a high savings rate
 The supply is influenced by monetary policy
implemented by the Federal Reserve System
 The Fed controls the amount of reserves held by depository
institutions
 The supply curve can shift in response to economic
conditions
 Households would save more funds during a strong
economy

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Loanable Funds Theory (cont’d)

SA

Aggregate Supply

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Loanable Funds Theory (cont’d)
 Equilibrium interest rate - algebraic
 The aggregate demand can be written as

DA  Dh  Db  Dg  Dm  Df

 The aggregate supply can be written as

S A  Sh  Sb  Sg  Sm  Sf

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Loanable Funds Theory (cont’d)

SA

DA

Equilibrium Interest Rate - Graphic

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Economic Forces That Affect
Interest Rates
 Economic growth
 Shifts 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
 Thecombined effect is an increase in the
equilibrium interest rate

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Loanable Funds Theory (cont’d)

SA

i2

DA2
DA

Impact of Economic Expansion

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Economic Forces That Affect
Interest Rates (cont’d)
 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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Loanable Funds Theory (cont’d)

SA2 S
A

i2

i
DA2
DA

Impact of Expected Increase in Inflation

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Economic Forces That Affect
Interest Rates (cont’d)
 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

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Economic Forces That Affect
Interest Rates (cont’d)
 Fisher effect (cont’d)
 Fisher effect equation:

i  E (INF )  i R
 The difference between the nominal interest rate
and the expected inflation rate is the real
interest rate:

i R  i  E (INF )

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Economic Forces That Affect
Interest Rates (cont’d)
 Money supply
 Ifthe Fed increases the money supply, the
supply of loanable funds increases
 If inflationary expectations are affected, the
demand for loanable funds may also increase
 Ifthe Fed reduces the money supply, the
supply of loanable funds decreases
 During 2001, the Fed increased the growth of
the money supply several times

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Economic Forces That Affect
Interest Rates (cont’d)
 Money supply (cont’d)
 September 11
 Firms cut back on expansion plans
 Households cut back on borrowing plans

 The demand of loanable funds declined

 The weak economy in 2001–2002

 Reduced demand for loanable funds
 The Fed increased the money supply growth

 Interest rates reached very low levels

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Economic Forces That Affect
Interest Rates (cont’d)
 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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Economic Forces That Affect
Interest Rates (cont’d)
 Foreign flows of funds
 Theinterest 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
 Shiftsin the flows of funds between countries cause
adjustments in the supply of funds available in each
country

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Economic Forces That Affect
Interest Rates (cont’d)
 Explaining the variation in interest rates over time
 Late 1970s: high interest rates as a result of strong economy
and inflationary expectations
 Early 1980s: recession led to a decline in interest rates
 Late 1980s: interest rates increased in response to a strong
economy
 Early 1990s: interest rates declined as a result of a weak
economy
 1994: interest rates increased as economic growth increased
 Drifted lower for next several years despite strong economic growth,
partly due to the U.S. budget surplus

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Forecasting Interest Rates
 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 Rates (cont’d)
 To forecast future interest rates, the net
demand for funds (ND) should be forecast:

ND  DA  S A

 Dh  Db  Dg  Dm  Df 

 Sh  Sb  Sg  Sm S f

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Forecasting Interest Rates (cont’d)

 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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