TOPIC 3

DETERMINING MARKET INTEREST RATES

DETERMINING THE LEVEL OF INTEREST RATES

Interest rate is the price of borrowing money. The level depends on supply and demand for loanable funds 2 ways to assess the demand/supply for loanable funds: Bond market perspective Loanable fund perspective

Supply of Loanable Funds or Demand for Bonds by Lenders

Copyright 2008 Pearson Addison-Wesley. All rights reserved.

6-3

Demand for Loanable Funds or Supply of Bonds by Borrowers

Copyright 2008 Pearson Addison-Wesley. All rights reserved.

6-4

Equilibrium in Markets for Bonds and Loanable Funds

Copyright 2008 Pearson Addison-Wesley. All rights reserved.

6-5

Loanable Funds Theory

Market interest rate is determined by the factors that control supply of and demand for loanable funds.

Demand for Loanable Funds

1. Household demand for loanable funds

-For purchases of house, automobiles, household items -Inverse relationship between the interest rate and the quantity of loanable funds demanded. -HHs demand greater qtty of loanable funds at lower rates of interest

2. Business demand for loanable funds

-Depends on number of business projects to be implemented. -More demand at lower interest rates -cost of borrowing

3. Government demand for loanable funds

7

-Interest inelastic: insensitive to interest rates. -Expenditures and tax policies are independent of the level of interest rates

Demand for Loanable Funds

4. Foreign demand for loanable funds

-A countrys demand for foreign funds depends on the interest rate differential between the two. -The greater the differential, the greater the demand for foreign funds. -The quantity of U.S. loanable funds demanded by foreign governments will be inversely related to U.S. interest rates.

5. Aggregate demand for loanable funds

Demand for Loanable Funds or Supply of Bonds by Borrowers

Copyright 2008 Pearson Addison-Wesley. All rights reserved.

6-9

Supply of Loanable Funds

1. Households are largest supplier, but some supplied by government units. 2. More supply at higher interest rates. 3. Supply by buying securities. 4. Effects of the Fed: By affecting the supply of loanable funds, Feds monetary policy affects interest rates. 5. Aggregate supply of funds

10

Supply of Loanable Funds or Demand for Bonds by Lenders

Copyright 2008 Pearson Addison-Wesley. All rights reserved.

6-11

Equilibrium Interest Rate

1. Aggregate Demand for funds (DA)

DA = Dh + Db + Dg + Dm + Df Dh = household demand for loanable funds Db = business demand for loanable funds Dg = federal government demand for loanable funds Dm = municipal government demand for loanable funds Df = foreign demand for loanable funds

2. Aggregate Supply of funds (SA)

S A = S h + Sb + Sg + Sm + S f Sh = household supply for loanable funds Sb = business supply for loanable funds Sg = federal government supply for loanable funds Sm = municipal government supply for loanable funds Sf = foreign supply for loanable funds

12

Equilibrium in Markets for Bonds and Loanable Funds

Copyright 2008 Pearson Addison-Wesley. All rights reserved.

6-13

Explaining Changes in Equilibrium Interest Rates

Factors affecting change in supply and demand for loanable funds The underlying economic forces that cause a changes in SS and DD for loanable funds
1. 2. 3. 4. 5. Economic conditions Inflation Monetary policy Budget deficit Foreign flows of funds
6-14

Shifts in the Demand Curve

Shifts in the Supply Curve

Figure 4.4 Shift in the Supply Curve for Bonds

Impact of Economic Growth on Interest Rates

1. Wealth Economy , wealth , Bd , Bd shifts out to right Profitability of Investment Opportunities
Business cycle expansion, investment opportunities , Bs , Bs shifts out to right Economic growth puts upward pressure on interest rates Economic slowdown puts downward pressure on interest rates

2.

Business Cycle Expansion

Evidence on Business Cycles and Interest Rates

Business Cycle and Interest Rates (Three-Month Treasury Bills), 19512004

Impact of Inflation on Interest Rates

Fisher hypothesis: the relationship between interest rate and expected inflation Nominal interest rate compensate savers in two ways: (i) compensate savers reduced purchasing power, (ii) Provide an additional premiun for savers to forgo current consumption in = ir + expected inflation So,

ir i

The real interest rate is the difference between nominal interest rate minus expected inflation.
Real interest rate more accurately reflects true cost of borrowing When real rate is low, greater incentives to borrow and less to lend Real interest rate more accurately the true return to saving

20

Distinction Between Real and Nominal Interest Rates (cont.)

Economy A. If i = 5% and e = 0% then

ir 5% 0% 5%

Economy B. If i = 10% and e = 20% then

ir 10% 20% 10%

21

Fisher Effect: Impact of Inflation on Interest Rates

If e 1. Relative Re , expected return on bond fall, Bd shifts in to left 2. Cost of borrowing is lower, Bs , Bs shifts out to right 3. P , i

22

Changes in e: The Fisher Effect

Summary of the Fisher Effect

1. If expected inflation rises from 5% to 10%, the expected return on bonds relative to real assets falls and, as a result, the demand for bonds falls

2.

The rise in expected inflation also means that the real cost of borrowing has declined, causing the quantity of bonds supplied to increase
When the demand for bonds falls and the quantity of bonds supplied increases, the equilibrium bond price falls Since the bond price is negatively related to the interest rate, this means that the interest rate will rise

3. 4.

24

Evidence on the Fisher Effect in the US

Expected Inflation and Interest Rates (Three-Month Treasury Bills),

Impact of Monetary Policy on Interest Rates

1. Central banks (CBs) can affect the supply on loanable funds
When CBs increase money supply, it increases the supply of loanable funds, placing downward pressure on interest rates
When CBs decrease money supply, it decreases the supply of loanable funds, placing upward pressure on interest rates

Figure 4.4 Shift in the Supply Curve for Bonds

Impact of Budget Deficit on Interest Rates

1. More expenditures than tax revenue, budget deficit increases Government demand loanable funds

2.

3.

Increases the demand for quantity of loanable funds demanded

Government Activities Deficits , Bs , Bs shifts out to right

4.

Impact of Foreign Flows of Funds on Interest Rates

1. Interest rates also determined by demand for funds denominated in that currency and supply of funds available in that currency Massive flows of funds between countries-give impact on supply of loanable funds, affecting interest rates Shifts in supply are driven by large institutional investors seeking for high returns on their investments

2. 3.

Assignment 1
Please do questions 3, 15 and 17 from page 45 of your text Submit next week Monday during class time

Copyright 2008 Pearson Addison-Wesley. All rights reserved.

6-29