BRUNEL UNIVERSITY LONDON

 
Department of Economics and Finance
 
EC1030 LECTURE 2

Theories of the determination of interest rates

Dr. Woo-Young Kang

 Lecture 2 Contents
1. The Loanable Funds Theory of Interest Rate Determination
2. Fisher’s Theory of Interest Rate Determination
3. The effect of Inflationary Expectations on the level of Interest Rates
4. Lecture 2 Summary
The Loanable Funds Theory of Interest
Rate Determination
Q: What are loanable funds?
A: They are funds available for lending in financial markets.
- The price of loanable funds can be thought of as the interest rate which
borrowers (deficit units) have to pay lenders (surplus units) to give up
their funds. Lending Funds
Lender Borrower
(Investor) (Issuer)
Paying Interest Rate

- Like any price in economics, equilibrium is determined by demand and

supply.
- Hence, the equilibrium interest rate is determined by the forces which
determine the demand for loanable funds and supply of loanable funds.
 Background Knowledge
Equilibrium Price =
Intersection between Supply and Demand

Interest Rate i
Loanable Fund Supply

Same logic applies for

Interest Rate Determination
i*

Loanable Fund Demand

Q* Loanable Fund Quantity

 (a) What sectors of the economy demand
loanable funds?
(1) Households: they demand Loanable Funds when buying houses, cars etc.
- Interest rate
- disposable income (income - taxes)
- Taxation

(2) Companies: they demand Loanable Funds when investing in projects.

- Projects they will invest in

(3) Governments: they demand Loanable Funds when their spending is greater than their revenues.
- Treasury Bills or Gilt-edged securities (gilts).
- Perfectly interest-inelastic

(4) Foreign government and firms: they also demand Loanable Funds.
- The interest rate differential between the two countries.
- Aggregate demand for Loanable Funds is inversely related to the interest rate at any one point in time.
(b) What factors influence the supply of
loanable funds?
• The supply of Loanable Fund is provided by savers.
- Households
- Firms
- Governments
- Foreign Governments

 Household sector is the largest supplier

Households demand Loanable Funds
• Households demand Loanable Funds when buying houses, cars
etc.
• Household demand for Loanable Funds can be thought of as
depending negatively on the interest rate.
• An increase in disposable income (income - taxes) would
have the effect of shifting the demand for Loanable Funds
schedule outwards.
• Likewise, a decrease in taxation would have the same effect
• Graph? Assume Loanable Funds Supply Curve is fixed!
Companies demand Loanable Funds
• Companies demand Loanable Funds when investing in projects.
• Obviously, the greater the price they have to pay (i.e. the higher
the rate of interest) for their loanable funds the fewer the
projects they will invest in.
• Thus, firm’s total demand for loanable funds can also be thought
of as being inversely related to the interest rate.
• Graph?
Governments demand
Loanable Funds
• Governments demand Loanable Funds when their spending is greater
than their revenues.
• They finance their additional spending by issuing more debt, usually in
the form of Treasury Bills or Gilt-edged securities (gilts).
• Unlike households and firms, government demand for debt (loanable
funds) is perfectly interest-inelastic i.e. their demand for Loanable
Funds does not depend on the rate of interest they have to pay for
those funds. e.g. If the budget is currently in deficit and an extra
million people become unemployed, the government has to pay them
no matter what the interest rate is.
• Graph?
Foreign government and firms
demand Loanable Funds
• Foreign government and firms also demand Loanable Funds.
• e.g. The U.S. government can obtain financing by issuing U.S. debt to U.K. investors. This
represents a U.S. demand for U.K. funds.
• A foreign country’s demand for U.K. funds depends on (along with other factors) the
interest rate differential between the two countries. In general, the higher is the
foreign country’s interest rate relative to our own, the greater will be the demand for U.K.
funds and vice-versa.
 Summing together the quantities demanded by each of these sectors
gives us the ‘aggregate demand for Loanable Funds.’
   As you would expect, the Aggregate Demand for Loanable Fund is
inversely related to the interest rate at any one point in time.
• Graph?
(c) How is the equilibrium interest rate
determined within the loanable funds
framework?
• The equilibrium interest rate is that interest rate which equates the
aggregate demand for Loanable Funds to the aggregate supply for Loanable
Funds i.e. interest rate ie.

• If the interest rate is above ie there will be an excess supply of Loanable

Funds and interest rate will fall until D = S.

• If the interest rate is below ie there will be an excess demand for Loanable
Funds and the interest rate will rise until an additional supply of Loanable
Funds is available to accommodate the excess demand.

• In general, whenever disequilibrium exists, market forces should cause an

adjustment in interest rate to restore equilibrium. Graph?
(d) What factors cause equilibrium interest
rates to change within the loanable
funds framework?
In general, any factor which causes either the aggregate demand
or supply curves to shift will cause equilibrium interest rates to
change.

Examples:
(1) – Increased expansion by firms
(2) – Recession
(3) – Increase in household’s propensity to save for retirement.
e.g.(1) - Increased expansion by firms
• Explain. Draw Graph.
e.g.(2) – Recession
• Explain. Draw Graph.
e.g.(3) - Increase in household’s
propensity to save for retirement
• Explain. Draw Graph.
 Fisher’s Theory of
Interest Rate Determination
Fisher effect
• As an alternative to the Loanable Funds Theory, Irving Fisher
put forward his Theory of Interest in 1930. Essentially, what
Fisher says is that in a situation of rising inflation lenders need
to raise nominal interest rates by at least the rate of inflation in
order to maintain the real purchasing power of their wealth.
• Fisher argued that what lenders should really be concerned
about is real interest rates, not nominal (market) interest rates
because real interest rates incorporate expected inflation.
Fisher effect (cont.)
Fisher effect (cont.)
• In a situation where prices are not expected to rise - i.e. no
inflation - the nominal interest rate will equal the real interest rate
and purchasing power will not be affected.
• In a situation where prices are rising, £1 today will not buy you the
same bundle of goods as £1 tomorrow. Hence, lenders will need to
be compensated by demanding a higher nominal interest rate in
order to maintain the real purchasing power of their wealth.
• This relationship between interest rates and the expected rate of
inflation is sometimes referred to as the Fisher effect.
The effect of Inflationary Expectations
on the level of Interest Rates
The effect of Inflationary Expectations
on the level of Interest Rates
• According to Fisher’s Theory, if inflation is expected to rise, savers will
demand a higher nominal interest rate in order to maintain the real
purchasing power of their wealth  the nominal interest rate will rise.
• According the Loanable Fund’s Theory, if inflation is expected to
increase households will increase their spending now before prices
increase  the demand for Loanable Funds will shift rightwards.
• for the same reason, households will be less willing to save  the
supply of Loanable Funds will shift leftwards, reinforcing the shift in
the demand curve thus causing interest rates to rise.
Lecture 2 Summary
• Interest rates determinations:
(1)Loanable funds theory
- Price of the loanable fund = interest rate
 the borrowers need to pay the lenders
- The interest rate is determined by the supply and demand of
loanable funds.
- Any factor causing either the aggregate demand or supply curves
to shift will cause equilibrium interest rate to change.
(2)Fisher’s theory : to maintain the real purchasing power of the lender’s
wealth.
Rr = Rn - E(I)