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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