Market Ch02

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Determination of Interest Rates

2

2003 South-Western/Thomson Learning

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Explain Loanable Funds Theory of Interest Rate Determination

Identify Major Factors Affecting the Level of Interest Rates

Explain How to Forecast Interest Rates

CHAPTER OBJECTIVES

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Household Sector--Usually a net supplier of loanable funds

Business SectorUsually a net demander in growth periods

Government Sectors- Borrow for capital projects and deficit spending

Foreign SectorsNet supplier since early 1980s

SECTORS OF THE ECONOMY

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Households demand loanable funds to finance housing, automobiles, household items

These purchases result in installment debt. Installment debt increases with the level ofincome

There is an inverse relationship between the interest rate and the quantity of loanablefunds demanded

LOANABLE FUNDS

THEORY:

DEMAND FORLOANABLE FUNDS

Household Demand for Loanable Funds

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LOANABLE FUNDS THEORY: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 projectsNet Present Value

If interest rates decrease, more projects will have a positive NPV.There is an inverse relationship between interest rates and the quantity

of loanable funds demandedBusinesses will need a greater amount of financing

Businesses will demand more loanable funds

n

t

t

t

k

CFNPV

0 )1(

Business Demand for Loanable Funds

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Municipal (state and local) governments issue municipal bonds

Federal government and its agencies issue Treasury securities and federal agencysecurities.

LOANABLE FUNDS

THEORY:


Government Demand for Loanable Funds

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When planned expenditures exceed revenues from taxes, thegovernment demands loanable funds

Federal government expenditure and tax policies are independent ofinterest rates. Government demand for funds is interest-inelastic

LOANABLE FUNDS

THEORY:


D

Interest

Rate

Quantity of Loanable Funds

Government Demand for Loanable Funds

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The aggregate demand for loanable funds is the sum of the quantities demanded by theseparate sectors

The aggregate demand for loanable funds is inversely related to interest rates

LOANABLE FUNDS

THEORY:


Aggregate Demand for Loanable Funds

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DEMAND FOR LOANABLE FUNDS

Interest

Rate


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Households are major suppliers of loanable funds

Businesses and governments may invest (loan) funds temporarily

Foreign sector a net supplier of funds

Variables other than interest rate changes causes a shift in the supply curve

SECTOR SUPPLY OF LOANABLE FUNDS

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Equilibrium Interest Rate

Aggregate Demand

DA

= Dh+ D

b+ D

g+ D

m+ D

f

Aggregate Supply

SA= Sh+ Sb+ Sg+ Sm+ Sf

In equilibrium, DA= SA

LOANABLE FUNDS THEORY

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Demand forLoanable Funds

Supply of

Loanable Funds

Interest

Rates


GRAPHIC PRESENTATION

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oIn case of debt capital, cost of money refers to the interest rate.

oIn case of equity capital, cost of money is the required return. This is thereturn expected by the shareholders to leave the share price unchanged.

THE COST OF MONEY

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i

EFFECTS OFINCREASED RISK

ON COST OFMONEY: LOANABLE

FUND THEORY

D (Investment)

S (Savings)

k

Quantity of Loanable Fund

S1

D1

k1

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Inflation

The Fisher Effect: in=ir+E(Inflation)

Nominal Interest Rates = Sum of Real Rate plus Expected Rate of 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 AFFECTINTEREST RATES

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Money Supply

When the Fed increases the money supply, it increases supply ofloanable funds. Places downward pressure on interest rates

Government Budget Deficit

Increase in deficit increases the quantity of loanable fundsdemanded. Demand schedule shifts outward, raising rates

Government is willing to pay whatever is necessary to borrowfunds, crowding out the private sector


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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 theworld


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Attempts to forecast demand/supply shifts

Forecast economic sector activity and impact upon demand/supply ofloanable funds

Forecast incremental effects on interest rates

Forecasting interest rates has been difficult

FORECASTING INTEREST RATES

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Economic GrowthIncreased growth; increaseddemand for funds; interest rates increase

Expected inflation--security prices fall; interest ratesincrease

Government budgets

Deficitincrease borrowing; security prices fall, interest ratesincrease

Surplusdecreased borrowing; security prices increase; interestrates decrease

Increased foreign supply of loanable fundssecurity

SUMMARY: KEY FACTORSIMPACTING INTEREST RATES OVER

TIME

Documents

Market Ch02