INTEREST RATES

The interest rates link the

future to the present.

Interest rates are determined

by the demand for and supply
of loanable funds.
The illustration shows, Higher
interest rates make it more costly
for investors to undertake capital
spending projects and for
consumers to buy now rather
than later.

Both investors and consumers

will curtail their borrowing as the
interest rate rises.
The amount of funds demanded
by borrowers is inversely related
to the interest rate.

Higher interest rates give people

willing to save the ability to
purchase more goods in the
future in exchange for sacrificing
current consumption.
As the interest rate rises, the
quantity of funds supplied to the
loanable funds market will
increase.

The interest rate will bring the

quantity of funds demanded into
balance with the quantity
supplied.
The equilibrium interest rate, the
quantity of funds borrowers
demand for investment and
consumption now will just equal
the quantity of funds lenders
save.

Therefore, the interest rate brings

the choices of borrowers and
lenders into harmony.
The rate of interest functions
as the price in the money
market.

Money has a time value, and

its use is bought and sold in
the money market in return for
the payment of interest.
The financial institutions the
deal in government securities
and loans, gold and foreign
exchange make up the money
market.

The money market is not a

specific physical location but
consists of transactions made
electronically or by phone.
Equilibrium in the money market
occurs when the MD and MS
curves intersect at the
equilibrium interest rate.
According to Keynesian
Theory, the rate of interest is
determined as a price in two
markets:
 Investment
Funds
● The rate of interest
balances the demand for
funds and the supply of
funds.
Example: If investors can earn
a 10% return on a capital
investment project they will be
willing to pay a rate of interest
of up to 10%.
Liquid
Assets
● Households and
businesses may have
reasons to hold assets in
liquid form.
Example: Because borrowers
require cash in the long-term
they are willing to compensate
lenders for giving up liquidity.
We have emphasized that the
interest rate is a premium paid by
borrowers for earlier availability
and a reward received by the
lenders for delaying consumption.

Analysis indicates that high rates

of inflation will lead to a high
money rate of interest. The real
world is consistent with this view.
Interest rates in the loanable funds
market will differ mainly because
of differences in the risks
associated with the loans.

The risk also increases with the

duration of the loan.
 The Three Components of Money Interest

● Pure-Interest Component - the real price one must pay for

earlier availability
● Inflationary Premium Component - reflects the expectation
that the loan will be repaid with pesos of less purchasing power
as the result of inflation
● Risk-Premium Component - reflects the probability of default
Short-term interest rates are
relevant for loans with a
relatively short length for
repayment while long-term
interest rates on the other hand,
are relevant for loans such as
long-term corporate borrowing
and 10-20-10 year fixed rate
mortgages.
 Higher Interest Lower Interest
Rates Rates
● Higher interest rates make ● Lower interest rates make
loans less affordable, it cheaper to take out
while high interest on loans, and hence to spend
savings accounts more money. Savings
encourages savings rather becomes less attractive as
than spending. interest rates are low.