Chapter 5

The Determinants of
Interest Rates:
Competing Ideas

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
 Learning Objectives
To understand the important roles that
interest rates play within the economy.

To explore the most important ideas about

what determines the level of interest rates
and asset prices within the financial system.

To learn what economists believe are the key

forces that set market interest rates and asset
prices into motion.

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 Coverage

Interest Rate Defined

Classical Theory of Interest Rate
Liquidity Preference Theory,
Loanable Funds Theory
 Introduction Rate of Interest

The acts of saving and lending, and

borrowing and investing, are significantly
influenced by and tied together by the
interest rate.

The interest rate is the price a borrower must

pay to secure scarce loanable funds from a
lender for an agreed-upon time period. Some
refer to this as the price of credit.

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 Rate of Interest

But unlike other prices in the economy, the

rate of interest is really a ratio of two
quantities: the money cost of borrowing
divided by the amount of money actually
borrowed, usually expressed on an annual
percentage basis.
 Introduction
Interest rates send price signals to borrowers,
lenders, savers, and investors.

Whether higher interest rates increase or decrease

savings and investment depends on the relative
strength of its effect on supply and demand factors.

Higher interest rates provide incentives to increase

supply of funds, but at same time they reduce the
demand for those funds.

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 Functions of the Interest Rate
in the Economy
Rate of Interest
Helps guarantee that current savings flow into
investment to promote economic growth

Generally allocates the available supply of credit

to investment projects with the highest expected
returns

Balances the supply of money with the publics

demand for money

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 Interest Rates - Functions

It is an important tool of government policy

through its influence on the volume of saving and
investment.

If the economy is growing too slowly and

unemployment is rising, the government can use its
policy tools to lower interest rates in order to stimulate
borrowing and investment.

On the other hand, an economy experiencing rapid

inflation has traditionally called for a government
policy of higher interest rates to slow borrowing and
spending and encourage more saving.
 The Interest Rate
Common reference to the interest rate
Multiple rates in economy
Even securities by the same borrower can have
differing rates
Focus on forces that impact all rates
Assume a single fundamental rate
Pure interest rate
Risk-free rate of interest
Opportunity cost of holding idle cash
Closest real-world equivalent is government bonds
rate

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 The Classical Theory of Interest Rates

One of the oldest theories concerning the

determinants of the pure or risk-free interest rate
in the classical theory of interest rates developed
during the nineteenth and early twentieth
centuries by a number of British economists and
elaborated on by Irving Fisher (1930) and others
more recently.

The classical theory of interest has been called a

long-term explanation of interest rates because it
focuses on the publics thrift habitsa fact that
tends to change slowly.
 The Classical Theory of Interest Rates

The classical theory is one of the oldest

interest rate theories
Rate of interest is determined by the balance of
two forces
Supply of savings, derived mainly from
households
Demand for investment capital, coming mainly
from the business sector

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 The classical Theory Supply Side

The classical theory states that the supply

of savings derived mainly from-

Saving by households
Saving by Business Firms
Saving by Government
 The Classical Theory of Interest Rates

Current household savings

Abstinence from consumption spending
Difference between current income and current
consumption expenditures

Individuals have a time preference for current

consumption
Prefer current enjoyment of goods and services over future
enjoyment
Payment of interest is a reward for waiting

Higher rates encourage the substitution of current

saving for current consumption
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 Wealth Effect

Timing and amount of savings

Current income and expected future income
Desired savings target
Propensity to save
Wealth

Wealth effect
Greater wealth tends to raise consumption
Strong during the late 1990s
Stock market and housing boom
Personal savings rate was negative

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The Classical Theory of Interest Rates

The Substitution Effect

Relating Savings and Interest Rates

Higher interest rates

increase the
Interest attractiveness of saving
Rate relative to consumption
spending, encouraging
r2 more individuals to
substitute current
saving ( and future
r1 consumption) for some
quantity of current
consumption.

S1 S2 Current
Saving

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 The Classical Theory of Interest Rates

Business savings
Savings balances in form of retained earnings
Primary financing for business investment
Principally determined by profits
Interest rates also impact savings

Higher profit if leads to higher retained

earnings then lower use of external financing
is a possibility and vice versa.

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 The Classical Theory of Interest Rates

Government savings
When the government has a budget
surplus
Major determinants
Income flows in the economy
Pacing of government spending
Rates impact cost of government debt

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 The Classical Theory of Interest Rates
Demand Side
Demand for investment funds
Primarily for businesses
Gross business investment equals the sum of
replacement investment and net investment
One investment decision-making method involves
the calculation of a projects expected internal
rate of return, and the comparison of that
expected return with the anticipated returns of
alternative projects, as well as with market
interest rates

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 Replacement and Net Investment

Replacement Investment is the expenditure to

replace equipment and facilities that are wearing
out or are technologically obsolete. Replacement
investment usually is more predictable and grows
at a more even rate than net investment.

A smaller but more dynamic form of business

capital spending is labeled as Net Investment:
expenditure to acquire new equipment and
facilities in order to increase output.

The sum of replacement investment plus net

investment equals gross investment.
 The Classical Theory of Interest Rates

The demand for investment funds-

The internal rate of return (r) equates the
total cost of an investment project with the
future net cash flows (NCF) expected from
that project discounted back to their present
values.
NCF1 NCF2 NCFn
Cost of project = ...
1 r 1 r
1 2
1 r n
Another method of investment analysis is the
net present value (NPV) approach.
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The Classical Theory of Interest Rates
The Cost of Capital and
the Business Investment Decision
Expected
Internal A acceptable
Rates of 15%
Return on B acceptable
Alternative Cost of
Investment 12% C indifferent Capital
Projects Funds
10% D = 10%
E
unprofitable 8%
unprofitable 7%

Dollar Cost of Investment Projects

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The Classical Theory of Interest Rates

The Investment Demand Schedule

In the Classical Theory of Interest Rates
Interest
Rate
r2
r1

Investment
I2 I1 Spending

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The Classical Theory of Interest Rates

The Equilibrium Rate of

Interest In the Classical Theory
Rate of Demand for
interest S
(% per D Investment
annum)
Volume
E
of Savings
rE

S D

QE = $200 billion
Volume of savings & investment ($billions)

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 The Classical Theory of Interest Rates

Limitations
Ignores factors other than savings and
investment that affect interest rates
For example, many financial institutions
can create money today by making
loans
Repaying the loan destroys money
Income and wealth are more important
than interest rates in determining savings
Traditionally businesses primary borrower
Now consumers major borrowers
Now governments major borrowers
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 The Liquidity Preference Theory of
Interest Rates

During the l930s British economist John

Maynard Keynes (1936) developed a short-
term theory of the rate of interest that, he
argued, was more relevant for policymakers
and for explaining near-term changes in
interest rates. This theory is known as the
liquidity preference (or cash balances)
theory of interest rates.
 The Liquidity Preference (Cash Balances)
Theory of Interest Rates

The liquidity preference (or cash

balances) theory of interest rates
Short-term theory
Developed for explaining near-term
changes in interest rates
More relevant for policymakers

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The Liquidity Preference (Cash Balances)
Theory of Interest Rates

Rate of interest is the payment

For the use of their scarce resource
(liquidity)
By those who demand liquidity
Assumed outlet for funds
Bonds
Cash Balances

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There are three elements of demand for
cash balances. These are:

1. Transaction Motive
2. Precautionary Motive
3. Speculative Motive
 The Liquidity Preference (Cash Balances)
Theory of Interest Rates
Transactions motive
Economic units do not have a perfect balance of
inflows and outflows
Hold liquidity for purchase of goods and services
Not overly sensitive to interest rates

Transactions demand in earlier theory

Dependent on level of national income
Dependent on business sales
Dependent on prices

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 1. Transaction Motive

Symbolically, the transaction demand for the

money function can be written as:

Lt = kt (Y)

Where Lt = Transaction Motive

kt = Constant Portion of Income
hold for transaction
Y = Income
The Liquidity Preference (Cash Balances)
Theory of Interest Rates

Precautionary motive
Cannot predict future expenditures precisely
Cope with future emergencies
Cover potential extraordinary expenses
E.g. unanticipated medical expense accidents,
unemployment, etc. For businessmen, future
expectation of prosperity or depression
influence the precautionary for money,
Greater in times of economic uncertainty
Not overly sensitive to interest rate movements

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 2. Precautionary Motive

Symbolically, the precautionary demand for the

money function can be written as:

Lp = kp (Y)

Where Lp = Precautionary Motive

kp = Constant Portion of Income
hold for precautionary
Y = Income
 T and P Demand Function

Higher levels of income, sales, or prices increase

the need for cash balances to carry out transactions
and to respond to future opportunities. However,
neither the precautionary nor the transactions
demand for money was assumed to be affected
significantly by changes in interest rates, but
remained fixed in the short term.

L1 = k(Y)

where L1 = Lt + Lp

And k(Y) = kt (Y) + kp (Y)

 Speculative Motive in the LPT

Speculative demand for money refers to the

demand for holding certain amount of cash in
reserve to make speculative gains out of purchase
or sale of bonds and securities through future
change in the rate of interest.

Thus demand for speculative motives is essentially

related with the rate of interest and bond prices.
The other major element determining interest
rates in liquidity preference theory is the supply of
money.
The Liquidity Preference (Cash Balances)
Theory of Interest Rates

Speculative motive
Demand due to uncertainty in future
bond prices
Change in interest rates
Changes bond prices
Demand for cash balances substitute
for bonds
High interest rates lead to high
opportunity cost of holding cash

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Speculative Demand for Money or
Cash Balances

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The Liquidity Preference (Cash Balances)
Theory of Interest Rates

Modern governments control or closely

regulate money supply
Decisions concerning the size of the money
supply presumably guided by the public
welfare
So assume the supply of money (cash
balances) is inelastic with respect to interest
rates
Represented by a vertical supply curve in
the equilibrium
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Total Demand for Money or Cash Balances
And the Equilibrium Rate of Interest

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 The Liquidity Preference (Cash Balances)
Theory of Interest Rates

Quantity of money demanded by public

equals supply provided by government
If the supply exceeds quantity demanded
at current interest rates
Buy bonds with excess funds
Decrease cash balances
Increase bond prices and lower interest rates
Useful insights
Rational at times to hoard or dishoard cash
Shows how central banks impact the markets5-40
 The Liquidity Preference (Cash Balances)
Theory of Interest Rates
Limitations
The liquidity preference theory is a short-
term theory
Assumption that income remains stable
does not hold in the long-term
Only the supply and demand for money is
considered
Fails to consider the supply and
demand for credit by all actors in
financial system - businesses,
households, and governments.

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 The Loanable Funds Theory of Interest

Loanable funds theory

Most popular practitioner theory
Risk-free interest rate is determined by the
interplay of two forces
the demand for credit (loanable funds),
domestic businesses, consumers, and
governments, as well as foreign borrowers
the supply of loanable funds from domestic
savings, dishoarding of money balances,
money creation by the banking system, as well
as foreign lending
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 The Loanable Funds Theory of Interest

The Demand for loanable funds

Consumer (household) demand is relatively
inelastic with respect to the rate of interest
Domestic business demand increases as the
rate of interest falls
Government demand does not depend
significantly upon the level of interest rates
Foreign demand is sensitive to the spread
between domestic and foreign interest rates

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The Loanable Funds Theory of Interest

Total Demand for Loanable Funds (Credit)

Interest
Rate
Total Demand = Dconsumer +
Dbusiness +
Dgovernment +
Dforeign

Amount of
Loanable Funds

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 The Loanable Funds Theory of Interest

The supply of loanable funds

Domestic savings. The net effect of
income, substitution, and wealth effects is
a relatively interest-inelastic supply of
savings curve
Dishoarding of money balances. When
individuals and businesses dispose of
their excess cash holdings, the supply of
loanable funds available to others is
increased

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 The Loanable Funds Theory of Interest

The supply of loanable funds

continued
Creation of credit by the domestic banking
system. Commercial banks and nonbank
thrift institutions offering payments
accounts can create credit by lending and
investing excess reserves
Foreign lending sensitive to the spread
between domestic and foreign rates
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The Loanable Funds Theory of Interest

Total Supply of Loanable Funds (Credit)

Interest
Rate Total Supply
= domestic savings +
newly created money +
foreign lending
hoarding demand

Amount of
Loanable Funds

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The Loanable Funds Theory of Interest

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 The Loanable Funds Theory of Interest

At equilibrium:
Planned savings = planned investment
across the whole economic system
Money supply = money demand
Supply of loanable funds = demand for
loanable funds
Net foreign demand for loanable funds =
net exports

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 The Loanable Funds Theory of Interest

Interest rates will be stable only when

the economy, money market, loanable
funds market, and foreign currency
markets are simultaneously in
equilibrium.

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Changes in the Demand for and Supply of
Loanable Funds

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Changes in the Demand for and Supply of
Loanable Funds

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 Markets on the Net

Bank Rate.com at www.bankrate.com

Bond Market Association at
www.investinginbonds.com
CNN/Money at www.cnnfn.com
European Central Bank at www.ecb.int/
Federal Reserve System at
www.federalreserve.gov
National Endowment for Financial Education
at www.nefe.org

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 Chapter Review

Introduction: interest rates and the

price of credit
Functions of the interest rate in the
economy
The classical theory of interest rates
Savings by households, business firms
and governments
The demand for investment funds
The equilibrium interest rate
Limitations of the classical theory
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 Chapter Review

The liquidity preference or cash

balances theory of interest rates
The demand for liquidity
The supply of money (cash balances)
The equilibrium interest rate
Limitations of the liquidity preference
theory

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 Chapter Review

The loanable funds theory of interest

The demand for loanable funds
The supply of loanable funds
The equilibrium interest rate

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