INTEREST RATE

DETERMINATION
 LOANABLE FUNDS THEORY
• It is a theory to explain interest rate
movements.
• The theory says that market interest rate is
determined by factors controlling the supply
of and demand for loanable funds.
 INTRODUCTION
• Interest is cost of debt.
• Interest rate movement have a direct
influence on the market values of debt
securities and an indirect influence on equity
securities.
• Thus participants in financial markets try to
anticipate interest rate movements when
restructuring their positions.
 What determines demand for loanable funds

Following determines demand:

(1)Household demand for loanable funds,
(2)Business demand for loanable funds,
(3)Government demand for loanable funds,
(4)Foreign demand for loanable funds.
Household demand for loanable fund
- Households generally demand loan to finance
housing expenditure and purchase of
automobiles and other household expenditure
which results instalment debt.
- Generally households will demand a greater
quantity of loanable funds at lower rate of
interest and vice-versa.
- Hence relationship between the interest rate
and quantity of loanable funds is inverse.
 Business demand for loanable funds
- Businesses demand loanable funds for
investment in long term assets and short term
assets.
- In case of requirement for investment in long
term assets the quantity of demanded depends
on the number of projects to be implemented.
- Businesses evaluate a project by computing NPV.
If NPV is positive project may be undertaken.
- When interest rate is lower then WACC is
lower and hence the Required Rate of Return
for computing NPV.
- When required rate of return is lower more
projects will have positive NPV and hence
demand for loanable funds will be more.
- Businesses also needs fund for short term
assets like inventory and receivables.
- Demand of funds for short term investment is positively related to
number of projects implemented.
- Hence interest rate and business demand for loanable funds are
inversely related.
- However business demand for loanable funds can change in
reaction to any events that affect business borrowing. For example,
if economic conditions become more favourable, the expected cash
flows on various proposed projects will increase.
- In this case expected return will exceed a particular required rate of
return and more and more projects will have positive NPV. It leads
to increase in demand of funds and rate of interest and demand of
funds will be positively related.
 Government demand for loanable funds

• Whenever a government’s planned expenditures

cannot be covered by its revenue from taxes and
other sources, it demands loanable funds.
• The federal government’s expenditure and tax
policies are considered to be independent of
interest rates.
• Thus federal government’s demand for funds is
referred to as interest inelastic or insensitive to
interest rates.
Foreign demand for loanable funds
• The demand for loanable funds in a given market also
includes demand by foreign governments or
corporations.
• For example, Ethiopian government may obtain
financing in USD by issuing Ethiopian treasury bonds to
US investors.
• A foreign country’s demand for US funds (i.e.
borrowing in USD) is influenced by the difference
between its own interest rates and US Rates.
• Other things being equal, Ethiopian government will
demand US funds more if US interest rate lower than
Ethiopian interest rate.
AGGREGATE DEMAND FOR LOANABLE
FUNDS
• It is the sum of the quantities demanded by
the separate sectors at a given interest rate.
• Generally aggregate demand for loanable
funds is inversely related to the prevailing
interest rate. It is because most of the sectors
demand has an inverse relationship with the
interest rate.
 SUPPLY OF LOANABLE FUNDS
• It generally refers to funds provided to
financial markets by savers.
• Suppliers of loanable funds also come from
following:
(1)Household supply of loanable funds
(2)Business supply of loanable funds
(3)Government supply of loanable funds
(4)Foreign supply of loanable funds
 Major observations on supply
• Household supplier is the largest supplier.
• Household as group are the net supplier of
loanable funds.
• Government and Businesses are net demanders
of loanable funds.
• Normally, suppliers are willing to supply more
funds if the interest rate (which is reward for
supplying funds) is higher, other things being
equal.
• Foreign household, government, and
businesses commonly supply funds to their
domestic markets by purchasing domestic
securities.
• Also, they have been a major creditor to the
US government by purchasing large amounts
of treasury securities.
 EQUILIBRIUM INTEREST RATE
Algebraic Presentation
• The equilibrium interest rate is the rate that
equates the aggregate demand for loanable
funds with aggregate supply of loanable funds.
• The aggregate demand of funds is expressed as:
Da = Dh + Db + Dg + Df
Here, Da = Aggregate Demand; Dh = Household demand;
Db = Business Demand; Dg = Govt Demand; Df = Foreign
Demand
• Likewise, Aggregate supply of funds (Sa) can be written
as:
Sa = Sh + Sb + Sg + Sf
- In equilibrium Da = Sa
- If Da is greater than Sa there will be a shortage of
loanable funds. Hence interest rate will rise until an
additional supply come to compensate the shortage.
- If Sa is greater than Da then interest rate will fall till
additional demand comes.
• Thanks……