Topic 1: An Understanding of Money & Interest Rates

What is interest rate?

The act of saving and lending, borrowing and investing, significantly
influenced and tied together by the interest rate.
It is the price a borrower must pay to secure scarce loanable funds from
a lender for an agreed-upon time period.
Some authorities refer interest rate as price of credit as it send price
signals to borrowers, lender, savers, and investors.

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Functions of the Interest Rate in the Economy
Facilitates the flow of current savings into investments that promote
economic growth.
Ex: Banks can attract household savings by offering interest on
deposits.

Allocates the available supply of credit to those investment project with

highest returns.
Ex: If interest rate is too high, therefore cost of borrowing will be high
and could cause profitable project making loses.

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Functions of the Interest Rate in the Economy
Adjustment in interest rates can bring the supply of money into
balance with demand.
Ex: If money supply exceeds demand, a decrease in interest rate
would occur and vice versa.

Act as important tool of government policy through their influence

on the volume of savings and investments.
Ex: If economy is growing slowly and unemployment is rising,
government can use its policy tools to lower interest rate to
stimulate borrowing and investment.

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Theory of Interest Rates

The Classical Theory

The classical theory argues that the rate of interest is determined by
two forces:
1. the supply of savings
2. the demand for investment capital
Supply of savings is positively related to the market interest rates.
Demand for investment capital is negatively related to the market
interest rates.
Equilibrium of interest rate supply = demand

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The Classical Theory - Supply of Savings

i) Household Savings
Current household savings equal to the difference between current
income and current consumption expenditures.
Individuals prefer current over future consumption, and the payment of
interest is a reward for waiting.
Higher interest rates encourage the substitution of current saving over
current consumption.

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The Classical Theory - Supply of Savings

ii) Business Savings

Most businesses hold savings balances in the form of retained
earnings, the amount of which is determined principally by business
profits, and to a lesser extent, by interest rates.

iii) Government Savings

Income flows in the economy and the pacing of government spending
programs are the dominant factors affecting government savings
(budget surplus).

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The Classical Theory - Supply of Savings

The Substitution Effect

Relating Savings and Interest Rates

Interest
Rate
r2
r1

Current
S1 S2 Saving

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The Classical Theory - Demand for Investment Funds

Gross business investment equals the sum of replacement investment

and net investment.
*Replacement investment = expenditures to replace equipment and
facilities that wearing out or technologically obsolete.
*Net investment = expenditures to acquire new equipment and
facilities to increase output.

Investment decision-making method involves the calculation of a

projects expected internal rate of return, and the comparison of
projects expected return with the expected returns of alternative
projects, as well as with market interest rates (cost of borrowing).

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The Classical Theory - Demand for Investment Funds

The Cost of Capital and the Business Investment Decision

Expected
Internal A acceptable
Rates of 15%
Return on B acceptable
Alternative Cost of
Investment 12% C indifferent Capital
Projects Funds
10% D = 10%
E
unprofitable 8%
unprofitable 7%

Dollar Cost of Investment Projects

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The Classical Theory - Demand for Investment Funds

The Investment Demand Schedule

In the Classical Theory of Interest Rates
Interest
Rate

r2

r1

Investment
I2 I1 Spending

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The Classical Theory Equilibrium Rate of Interest

The Equilibrium Rate of Interest In the Classical Theory

Interest
Rate Investment Savings

rE

Savings &
QE Investment

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Limitations of The Classical Theory
The theory ignores factors other than saving and investment that affect
interest rates.
The theory assumes that interest rates are the principal determinant of
the quantity of savings available.
The theory contends that the demand for borrowed funds comes
principally from the business sector.

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Theory of Interest Rates
The Liquidity Preference (Cash Balances) Theory
The liquidity preference (or cash balances) theory of interest rates is a
short-term theory explaining near-term changes in interest rates, more
relevant for policymakers.
According to the theory, the interest rate refers to a payment to supplier
of funds for the use of scarce resource (money or cash balances) by the
demander.
To classical theorist, it was irrational to hold cash as it provides little or
no return.

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The Liquidity Preference (Cash Balances) Theory

The demand for liquidity stems from:

1. the transactions motive the purchase of goods and services
2. the precautionary motive to cope with future emergencies and
extraordinary expenses
3. the speculative motive uncertainty about future prices of
financial assets

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The Total Demand for Money or Cash Balances & the Equilibrium
Rate of Interest

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The Total Demand for Money or Cash Balances & the Equilibrium
Rate of Interest
In modern economies, the money supply is controlled and closely
regulated by the government.

The supply of money (cash balances) is often assumed to be inelastic

with respect to interest rates, since government decisions concerning
the size of the money supply should presumably be guided by public
welfare (not by interest rate).

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The Liquidity Preference (Cash Balances) Theory

The Equilibrium Interest Rate

In the Liquidity Preference Theory

Interest
Rate Money
Supply

Equilibrium
interest rate Total
Demand

Quantity of
Money / Cash
QE Balances

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Limitations of The Liquidity Preference (Cash Balances) Theory
It is a short-term approach that fails to capture the fact that over a
longer term period, interest rates are affected by changes in level of
income and inflationary expectations.
It is impossible to have a stable equilibrium interest rate without
reaching equilibrium level of income, savings and investments in the
economy.
It only considers supply and demand for money (cash) whereas
business, consumer and government demands for financing have
impact on cost of financing.

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Theory of Interest Rates
The Loanable Funds Theory
The theory argues that the risk-free interest rate is determined by the
interplay of two forces:
1. the demand for loanable funds by domestic businesses,
consumers, and governments, as well as foreign borrowers
2. the supply of loanable funds from domestic savings, dishoarding
of money balances, money creation by the banking system, as
well as foreign lending

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The Loanable Funds Theory
Loanable funds?
The sum total of all the money people and entities in an economy
decided to save and lend out to borrowers as an investment rather than
use for personal consumption.

The Demand for Loanable Funds

Consumer (household) demand is relatively inelastic with respect to
the rate of interest.
Domestic business demand increases as the rate of interest falls.
Government demand does not depend significantly upon the level of
interest rates.
Foreign demand is sensitive to the spread between domestic and
foreign interest rates.
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The Loanable Funds Theory

Total Demand for Loanable Funds (Credit)

Interest Rate

Total Demand = Dconsumer +

Dbusiness +
Dgovernment +
Dforeign

Amount of
Loanable Funds

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The Loanable Funds Theory
The Supply of Loanable Funds
Domestic Savings. The net effect of income, substitution and wealth
effects is a relatively interest-inelastic supply of savings curve.
Dishoarding of Money Balances. When individuals and businesses
dispose of their excess cash holdings, the supply of loanable funds
available to others is increased.
Creation of Credit by the Domestic Banking System. Commercial
banks and nonbank thrift institutions can create credit by lending and
investing their excess reserves.
Foreign lending is sensitive to the spread between domestic and
foreign interest rates.

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The Loanable Funds Theory

Total Supply of Loanable Funds (Credit)

Interest Rate
Total Supply
= domestic savings +
newly created money +
foreign lending
hoarding demand

Amount of
Loanable Funds

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The Loanable Funds Theory

The Equilibrium Interest Rate

Interest Rate
Supply

rE
Demand
Amount of
QE Loanable Funds

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The Loanable Funds Theory
At equilibrium:
1. Planned savings = planned investment across the whole economic
system
2. Money supply = money demand
3. Supply of loanable funds = demand for loanable funds
4. Net foreign demand for loanable funds = net exports
Interest rates will be permanently stable only when the economy,
money market, loanable funds market, and foreign currency markets are
simultaneously in equilibrium.

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The Loanable Funds Theory
Effects of increased supply of loanable funds with demand unchanged

Interest Rate

D0 S1
S2

I1
I2

Amount of
C1 C2 Loanable Funds

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The Loanable Funds Theory
Effects of increased demand of loanable funds with supply unchanged

Interest Rate

D2 S0
D1

I2
I1

Amount of
Loanable Funds
C1 C2

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Theory of Interest Rates
The Rational Expectations Theory
The rational expectations theory builds on research evidences that the
money and capital markets are highly efficient in digesting new
information that affects interest rates and security prices.
For example, when new information appears about investment, saving
or the money supply, investors begin immediately to translate the new
information into decision to lend or to borrow funds.

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The Rational Expectations Theory
If the money and capital markets are highly efficient, then interest rates
will always be very near their equilibrium levels.
Interest rates will change only if entirely new and unexpected
information appears, and the direction of change depends on the
publics current set of expectations.

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The Rational Expectations Theory
The public forms rational and unbiased expectations about the future
demand and supply of credit, and hence interest rates.

Interest Rate

Expected Supply

rE

Expected Demand
Amount of
QE Loanable Funds

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