CHAPTER

Determination of
2 Interest Rates

© 2003 South-Western/Thomson Learning

Chapter Objectives

n Explain Loanable Funds Theory of Interest

Rate Determination
n Identify Major Factors Affecting the Level of
Interest Rates
n Explain How to Forecast Interest Rates
Relevance of Interest Rate Movements
n Changes in interest rates impact the real economy
l Investment spending
l Interest sensitive consumer spending such as housing
n Interest rate changes affect the values of all securities
l Security prices vary inversely with interest rates
l Varying interest rates impact retirement funds and retirement
income
n Interest rates changes impact the value of financial
institutions
l Managers of financial institutions closely monitor rates
l Interest rate risk is a major risk impacting financial
institutions
Loanable Funds Theory of Interest Rate
Determination
n Theory of how the general level of interest
rates are determined
n Explains how economic and other factors
influence interest rate changes
n Interest rates determined by demand and
supply for loanable funds
Loanable Funds Theory, cont.

n Demand = borrowers, issuers of securities,

deficit spending unit
n Supply = lenders, financial investors, buyers
of securities, surplus spending unit
n Assume economy divided into sectors
n Slope of demand/supply curves related to
elasticity or sensitivity of interest rates
Sectors of the Economy

n Household Sector--Usually a net supplier of

loanable funds
n Business Sector—Usually a net demander in
growth periods
n Government Sectors
l States—Borrow for capital projects
l Federal—Borrow for capital projects and deficit
spending
n Foreign Sectors—Net supplier since early
1980’s
Demand for Loanable Funds

n Sum of sector demand (quantity) at varying

levels of interest rates
n Sector cash receipts in period less than outlays
= borrower
n Quantity demanded inversely related to
interest rates
n Variables other than interest rate changes
cause shift in demand curve
Demand for Loanable Funds

Interest
Rate

Quantity of Loanable Funds

Loanable Funds Theory

Household Demand for Loanable Funds

l Households demand loanable funds to finance

housing, automobiles, household items
l These purchases result in installment debt.
Installment debt increases with the level of income
l There is an inverse relationship between the interest
rate and the quantity of loanable funds demanded
Loanable Funds Theory

Business Demand for Loanable Funds

l Businesses demand loanable funds to invest in

assets
l Quantity of funds demanded depends on how
many projects to be implemented
u Businesses choose projects by calculating the project’s
Net Present Value
u Select all projects with +NPV’s
Loanable Funds Theory

Business Demand for Loanable Funds

Net Present Value is calculated as follows:

n
NPV = –INV + 
t=1
CFt
(1 + k)t
Loanable Funds Theory

Business Demand for Loanable Funds

l Projects with a positive NPV are accepted because

the present value of their benefits outweighs their
costs
l If interest rates decrease, more projects will have a
positive NPV
u Businesses will need a greater amount of financing
u Businesses will demand more loanable funds
Loanable Funds Theory

Business Demand for Loanable Funds

l There is an inverse relationship between interest rates

and the quantity of loanable funds demanded
l The curve can shift in response to events that affect
business borrowing preferences
u Example: Economic conditions become more favorable
u Expected cash flows will increase > more positive NPV
projects > increased demand for loanable funds
Loanable Funds Theory

Government Demand for Loanable Funds

l When planned expenditures exceed revenues from

taxes, the government demands loanable funds
l Municipal (state and local) governments issue
municipal bonds
l Federal government and its agencies issue
Treasury securities and federal agency securities.
Loanable Funds Theory

Government Demand for Loanable Funds

l Federal government expenditure and tax policies
are independent of interest rates
l Government demand for funds is interest-inelastic
Interest
Rate

D
Quantity of Loanable Funds
Loanable Funds Theory

Foreign Demand for Loanable Funds

l A foreign country’s demand for U.S. funds is

influenced by the differential between its interest
rates and U.S. rates
l The quantity of U.S. loanable funds demanded by
foreign investors will be inversely related to U.S.
interest rates
Loanable Funds Theory

Aggregate Demand for Loanable Funds

l The aggregate demand for loanable funds is the

sum of the quantities demanded by the separate
sectors
l The aggregate demand for loanable funds is
inversely related to interest rates
Sector Supply of Loanable Funds

n Households are major suppliers of loanable

funds
n Businesses and governments may invest (loan)
funds temporarily
n Foreign sector a net supplier of funds in last
twenty years
n Federal Reserve’s monetary policy impacts
supply of loanable funds
Supply of Loanable Funds

n Sum of sector supply (quantity) at varying

levels of interest rates
n Sector cash receipts in period greater than
outlays—lender
n Quantity supplied directly related to interest
rates
n Variables other than interest rate changes
causes a shift in the supply curve
Interest
Rate S

Quantity of Loanable Funds

Loanable Funds Theory

n Equilibrium Interest Rate

l Aggregate Demand
DA = Dh + Db + Dg + Dm + Df

l Aggregate Supply
SA = Sh + Sb + Sg + Sm + Sf

In equilibrium, DA = SA
Graphic Presentation

Interest Supply of
Rates Loanable Funds

Demand for
Loanable Funds

Quantity of Loanable Funds

Loanable Funds Theory

n Graphic Presentation
l When a disequilibrium situation exists, market
forces should cause an adjustment in interest
rates until equilibrium is achieved
u Example: interest rate above equilibrium
u Surplus of loanable funds
u Rate falls
u Quantity supplied reduced, quantity demanded
increases until equilibrium
General Equilibrium Interest Rate

n Means of explaining how economic factors

affect interest rate levels
n Interest rate level where quantity of aggregate
loanable funds demanded = supply
n Surplus and shortage conditions
l Surplus- Quantity demanded < quantity supplied
followed by market interest rate decreases
l ShortageGovernment interest rate ceilings below
market interest rates
Interest Rate Changes

n + Directly related to level of economic activity

or growth rate of economic activity
n + Directly related to expected inflation
n – Inversely related to rates of money supply
changes
Economic Forces That Affect Interest
Rates
n Economic Growth
l Expected impact is an outward shift in the demand
schedule without obvious shift in supply
l New technological applications with +NPV’s
l Result is an increase in the equilibrium interest
rate
Economic Forces That Affect Interest
Rates: The Fisher Effect
n Lenders want to be compensated for expected
loss of purchasing power (inflation) when they
lend
n Nominal Interest Rates = Sum of real rate plus
expected rate of inflation, i n = E(I) + i r
n Expected Real Rate (ex ante) = expected
increase in purchasing power in period
n Realized Real Rate (ex post) = nominal rates
less actual rate of inflation in period
Economic Forces That Affect Interest
Rates
n Inflation
l The Fisher Effect
u Nominal Interest Rates = Sum of Real Rate plus
Expected Rate of Inflation

in = ir + E(I)
Figure 2.12 here
20
Annualized
Real
Interest Rate
15 Annualized
Inflation

Annualized
10 T-Bill
Rate

-5
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
Year
Economic Forces That Affect Interest
Rates
n Inflation
l If inflation is expected to increase
u Households may reduce their savings to make purchases
before prices rise
u Supply shifts to the left, raising the equilibrium rate
u Also, households and businesses may borrow more to
purchase goods before prices increase
u Demand shifts outward, raising the equilibrium rate
Economic Forces That Affect Interest
Rates

n Money Supply
l When the Fed increases the money supply, it
increases supply of loanable funds
l Places downward pressure on interest rates
Economic Forces That Affect Interest
Rates
n Federal Government Budget Deficit
l Increase in deficit increases the quantity of
loanable funds demanded
l Demand schedule shifts outward, raising rates
l Government is willing to pay whatever is
necessary to borrow funds, “crowding out” the
private sector
Economic Forces That Affect Interest
Rates
n Foreign Flows
l In recent years there has been massive flows
between countries
l Driven by large institutional investors seeking
high returns
l They invest where interest rates are high and
currencies are not expected to weaken
l These flows affect the supply of funds available in
each country
l Investors seek the highest real after-tax, exchange
rate adjusted rate of return around the world
Forecasting Interest Rates

n Attempts to forecast demand/supply shifts

n Forecast economic sector activity and impact
upon demand/supply of loanable funds
n Forecast incremental effects on interest rates
n Forecasting interest rates has been difficult
Summary: Key Factors Impacting
Interest Rates Over Time
n Economic Growth—Increased growth; increased
demand for funds; interest rates increase
n Expected inflation--security prices fall; interest rates
increase
n Government budgets
l Deficit—increase borrowing; security prices fall, interest
rates increase
l Surplus—decreased borrowing; security prices increase;
interest rates decrease
n Increased foreign supply of loanable funds—security
prices increase; interest rates decrease