Fmi7e ch02

Chapter 2 Determination of Interest Rates

Financial Markets and Institutions, 7e, Jeff Madura Copyright Š2006 by South-Western, a division of Thomson Learning. All rights reserved.

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Chapter Outline Loanable funds theory  Economic forces that affect interest rates  Forecasting interest rates 

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Loanable Funds Theory 

Loanable funds theory suggests that the market interest rate is determined by the factors that affect the supply of and demand for loanable funds  Can

be used to explain movements in the general level of interest rates of a particular country  Can be used to explain why interest rates among debt securities of a given country vary

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Loanable Funds Theory (cont’d) 

Household demand for loanable funds  Households

finance

demand loanable funds to

Housing expenditures  Automobiles  Household items 

 There

is an inverse relationship between the interest rate and the quantity of loanable funds demanded 4

Loanable Funds Theory (cont’d) 

Business demand for loanable funds  

Businesses demand loanable funds to invest in fixed assets and short-term assets Businesses evaluate projects using net present value (NPV): n

CFt NPV = −INV + t ( 1 + k ) t =1

∑





Projects with a positive NPV are accepted

There is an inverse relationship between interest rates and business demand for loanable funds

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Loanable Funds Theory (cont’d) 

Government demand for loanable funds  Governments

demand funds when planned expenditures are not covered by incoming revenues Municipalities issue municipal bonds  The federal government issues Treasury securities and federal agency securities 

 Government

demand for loanable funds is interest-inelastic 6

Loanable Funds Theory (cont’d) 

Foreign Demand for loanable funds  Foreign

demand for U.S. funds is influenced by the interest rate differential between countries  The quantity of U.S. loanable funds demanded by foreign governments or firms is inversely related to U.S. interest rates  The foreign demand schedule will shift in response to economic conditions 7

Loanable Funds Theory (cont’d) 

Aggregate demand for loanable funds  The

sum of the quantities demanded by the separate sectors at any given interest rate is the aggregate demand for loanable funds

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Loanable Funds Theory (cont’d)

Dh

Household Demand

Db

Business Demand

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Loanable Funds Theory (cont’d)

Dg

Federal Government Demand

Dm

Municipal Government Demand

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Loanable Funds Theory (cont’d)

Df

Foreign Demand

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Loanable Funds Theory (cont’d)

DA

Aggregate Demand

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Loanable Funds Theory (cont’d) 

Supply of loanable funds  Funds

are provided to financial markets by

Households (net suppliers of funds)  Government units and businesses (net borrowers of funds) 

 Suppliers

of loanable funds supply more funds at higher interest rates

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Loanable Funds Theory (cont’d) 

Supply of loanable funds (cont’d)  Foreign

households, governments, and corporations supply funds by purchasing Treasury securities 

Foreign households have a high savings rate

 The

supply is influenced by monetary policy implemented by the Federal Reserve System 

The Fed controls the amount of reserves held by depository institutions

 The

supply curve can shift in response to economic conditions 

Households would save more funds during a strong economy

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Loanable Funds Theory (cont’d) SA

Aggregate Supply

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Loanable Funds Theory (cont’d) 

Equilibrium interest rate - algebraic  The

aggregate demand can be written as

DA = Dh + Db + Dg + Dm + Df  The

aggregate supply can be written as

S A = S h + S b + S g + S m + Sf

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Loanable Funds Theory (cont’d) SA

i DA

Equilibrium Interest Rate - Graphic

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Economic Forces That Affect Interest Rates 

Economic growth  Shifts

the demand schedule outward (to the

right)  There is no obvious impact on the supply schedule 

Supply could increase if income increases as a result of the expansion

 The

combined effect is an increase in the equilibrium interest rate 18

Loanable Funds Theory (cont’d) SA i2 i DA2 DA Impact of Economic Expansion

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Economic Forces That Affect Interest Rates (cont’d) 

Inflation  Shifts 

the supply schedule inward (to the left)

Households increase consumption now if inflation is expected to increase

 Shifts

the demand schedule outward (to the

right) 

Households and businesses borrow more to purchase products before prices rise

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Loanable Funds Theory (cont’d) SA2 S A i2 i DA2 DA Impact of Expected Increase in Inflation

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Economic Forces That Affect Interest Rates (cont’d) 

Fisher effect  Nominal

interest payments compensate savers for: Reduced purchasing power  A premium for forgoing present consumption 

 The

relationship between interest rates and expected inflation is often referred to as the Fisher effect 22

Economic Forces That Affect Interest Rates (cont’d) 

Fisher effect (cont’d)  Fisher

effect equation:

i = E (INF ) + i R  The

difference between the nominal interest rate and the expected inflation rate is the real interest rate:

i R = i − E (INF ) 23

Economic Forces That Affect Interest Rates (cont’d) 

Money supply  If

the Fed increases the money supply, the supply of loanable funds increases 

If inflationary expectations are affected, the demand for loanable funds may also increase

 If

the Fed reduces the money supply, the supply of loanable funds decreases  During 2001, the Fed increased the growth of the money supply several times 24

Economic Forces That Affect Interest Rates (cont’d) 

Money supply (cont’d)  September

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Firms cut back on expansion plans  Households cut back on borrowing plans  The demand of loanable funds declined 

 The

weak economy in 2001–2002

Reduced demand for loanable funds  The Fed increased the money supply growth  Interest rates reached very low levels 

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Economic Forces That Affect Interest Rates (cont’d) 

Budget deficit 

A high deficit means a high demand for loanable funds by the government  



The government may be willing to pay whatever is necessary to borrow funds, but the private sector may not 



Shifts the demand schedule outward (to the right) Interest rates increase

Crowding-out effect

The supply schedule may shift outward if the government creates more jobs by spending more funds than it collects from the public

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Economic Forces That Affect Interest Rates (cont’d) 

Foreign flows of funds  The

interest rate for a currency is determined by the demand for and supply of that currency 

Impacted by the economic forces that affect the equilibrium interest rate in a given country, such as:  

Economic growth Inflation

 Shifts

in the flows of funds between countries cause adjustments in the supply of funds available in each country 27

Economic Forces That Affect Interest Rates (cont’d) 

Explaining the variation in interest rates over time     

Late 1970s: high interest rates as a result of strong economy and inflationary expectations Early 1980s: recession led to a decline in interest rates Late 1980s: interest rates increased in response to a strong economy Early 1990s: interest rates declined as a result of a weak economy 1994: interest rates increased as economic growth increased 

Drifted lower for next several years despite strong economic growth, partly due to the U.S. budget surplus

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Forecasting Interest Rates ď Ž

It is difficult to predict the precise change in the interest rate due to a particular event  Being

able to assess the direction of supply or demand schedule shifts can help in understanding why rates changed

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Forecasting Interest Rates (cont’d) 

To forecast future interest rates, the net demand for funds (ND) should be forecast:

ND = DA − S A

[

] +S ]

= Dh + Db + Dg + Dm + Df

[

− Sh + Sb + Sg + Sm

f

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Forecasting Interest Rates (cont’d) A positive disequilibrium in ND will be corrected by an increase in interest rates  A negative disequilibrium in ND will be corrected by a decrease in interest rates 

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