Ch02 rev

Chapter 2 Determination of Interest Rates

Š 2001 South-Western College Publishing Company

1

Relevance of Interest Rate Movements Interest rate movements affect the values of virtually all securities They have a direct influence on debt instruments • Bonds, Mortgages They have an indirect influence on stocks and exchange rates Interest rates affect the value of financial institutions Managers of financial institutions closely monitor rates 2

Loanable Funds Theory Commonly used to explain interest rate movements Suggests that market interest rates are determined by the supply and demand for loanable funds Some sectors of the economy supply loanable funds, other demand loanable funds

3

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 4

Interest Rate

D

Quantity of Loanable Funds 5

Loanable Funds Theory Household Demand for Loanable Funds Events can cause household borrowing preferences to change, shifting demand schedule • Example: tax rates are expected to decrease – Households believe that they can more easily afford future loan payments – They are willing to borrow more – For any interest rate => greater quantity of loanable funds demanded => outward shift 6

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 project’s Net Present Value

7

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 8

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 9

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.

10

Loanable Funds Theory Government Demand for Loanable Funds Federal government expenditure and tax policies are independent of interest rates Government demand for funds is interestinelastic Interest Rate

D Quantity of Loanable Funds

11

Loanable Funds Theory Foreign Demand for Loanable Funds A foreign country’s 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

12

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

13

Loanable Funds Theory Supply of Loanable Funds Refers to funds provided to financial markets by savers The household sector is the largest supplier Loanable funds are also supplied by • Governmental units that temporarily have excess funds • Businesses whose cash inflows exceed outflows 14

Loanable Funds Theory Supply of Loanable Funds Households, as a group, are net suppliers of loanable funds Governments and businesses are net demanders of loanable funds Suppliers of loanable funds are willing to supply more funds if interest rates are higher • There is a direct relationship between quantity of loanable funds supplied and the interest rate 15

Loanable Funds Theory Supply of Loanable Funds In the United States, the supply of loanable funds is also influenced by the monetary policy of the Federal Reserve • The Fed controls the amount of reserves held by depository institutions and can influence the amount of savings available for loanable funds 16

Interest Rate

S

Quantity of Loanable Funds 17

Graphic Presentation

Interest Rates

Supply of Loanable Funds

Demand for Loanable Funds

Quantity of Loanable Funds 18

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 19

Economic Forces That Affect Interest Rates Economic Growth Inflation Money Supply Budget Deficit Foreign Flows of Funds

20

Economic Forces That Affect Interest Rates Economic Growth Expected impact is an outward shift in the demand schedule without obvious shift in supply Result is an increase in the equilibrium interest rate

21

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

22

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

23

Economic Forces That Affect Interest Rates 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 24

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 25