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CHAPTER

Determination of
Interest Rates

2003 South-Western/Thomson Learning

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

Relevance of Interest Rate Movements

Changes in interest rates impact the real economy

Interest rate changes affect the values of all securities

Investment spending
Interest sensitive consumer spending such as housing
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

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

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

Sectors of the Economy


Household Sector--Usually a net supplier of
loanable funds
Business SectorUsually a net demander in
growth periods
Government Sectors

StatesBorrow

for capital projects


FederalBorrow for capital projects and deficit
spending

Foreign SectorsNet supplier since early


1980s

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

Demand for Loanable Funds


Interest
Rate

Quantity of Loanable Funds

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

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 projects


Net Present Value
Select all projects with +NPVs

Loanable Funds Theory


Business Demand for Loanable Funds
Net Present Value is calculated as follows:
n

NPV = INV +

t=1

CFt
(1 + k)t

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

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

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.

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

Loanable Funds Theory

Foreign Demand for Loanable Funds


A foreign

countrys 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

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

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 Reserves monetary policy impacts
supply of loanable funds

Supply of Loanable Funds


Sum of sector supply (quantity) at varying
levels of interest rates
Sector cash receipts in period greater than
outlayslender
Quantity supplied directly related to interest
rates
Variables other than interest rate changes
causes a shift in the supply curve

Interest
Rate

Quantity of Loanable Funds

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

Graphic Presentation
Interest
Rates

Supply of
Loanable Funds

Demand for
Loanable Funds

Quantity of Loanable Funds

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

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

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

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 +NPVs
Result is an increase in the equilibrium interest
rate

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, i n = 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

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)

Figure 2.12 here


20
Annualized
Real
Interest Rate
15

Annualized
Inflation
Annualized
T-Bill
Rate

10

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

Year

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

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

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

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

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

Summary: Key Factors Impacting


Interest Rates Over Time

Economic GrowthIncreased growth; increased


demand for funds; interest rates increase
Expected inflation--security prices fall; interest rates
increase
Government budgets

Deficitincrease borrowing; security prices fall, interest


rates increase
Surplusdecreased borrowing; security prices increase;
interest rates decrease

Increased foreign supply of loanable fundssecurity


prices increase; interest rates decrease