1. Determination of Interest Rates
Chapter 2
Determination of Interest Rates
© 2001 South-Western College Publishing Company

2. Relevance of Interest Rate Movements
Interest rate movements affect the values of virtually all securities
They have a direct influence on debt instruments
Bonds, Mortgages
They have an indirect influence on stocks and exchange rates
Interest rates affect the value of financial institutions
Managers of financial institutions closely monitor rates

3. Loanable Funds Theory Commonly used to explain interest rate movements
Suggests that market interest rates are determined by the supply and demand for loanable funds
Some sectors of the economy supply loanable funds, other demand loanable funds

4. Loanable Funds Theory Household Demand for Loanable Funds
Households demand loanable funds to finance housing, automobiles, household items
These purchases result in installment debt. Installment debt increases with the level of income
There is an inverse relationship between the interest rate and the quantity of loanable funds demanded

5. Interest
Rate D
Quantity of Loanable Funds

6. Loanable Funds Theory Household Demand for Loanable Funds
Events can cause household borrowing preferences to change, shifting demand schedule
Example: tax rates are expected to decrease
Households believe that they can more easily afford future loan payments
They are willing to borrow more
For any interest rate => greater quantity of loanable funds demanded => outward shift

7. Loanable Funds Theory Business 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 project’s Net Present Value

8. Loanable Funds Theory Business Demand for Loanable Funds
Projects with a positive NPV are accepted because the present value of their benefits outweighs their costs
If interest rates decrease, more projects will have a positive NPV
Businesses will need a greater amount of financing
Businesses will demand more loanable funds

9. Loanable Funds Theory Business Demand for Loanable Funds
There is an inverse relationship between interest rates and the quantity of loanable funds demanded
The curve can shift in response to events that affect business borrowing preferences
Example: Economic conditions become more favorable
Expected cash flows will increase => more positive NPV projects => increased demand for loanable funds

10. Loanable Funds Theory Government Demand for Loanable Funds
When planned expenditures exceed revenues from taxes, the government demands loanable funds
Municipal (state and local) governments issue municipal bonds
Federal government and its agencies issue Treasury securities and federal agency securities.

11. Loanable Funds Theory Government Demand for Loanable Funds
Federal government expenditure and tax policies are independent of interest rates
Government demand for funds is interest-inelastic
Interest
Rate D
Quantity of Loanable Funds

12. Loanable Funds Theory Foreign Demand for Loanable Funds
A foreign country’s demand for U.S. funds is influenced by the differential between its interest rates and U.S. rates
The quantity of U.S. loanable funds demanded by foreign investors will be inversely related to U.S. interest rates

13. Loanable Funds Theory Aggregate Demand for Loanable Funds
The aggregate demand for loanable funds is the sum of the quantities demanded by the separate sectors
The aggregate demand for loanable funds is inversely related to interest rates

14. Loanable Funds Theory Supply of Loanable Funds
Refers to funds provided to financial markets by savers
The household sector is the largest supplier
Loanable funds are also supplied by
Governmental units that temporarily have excess funds
Businesses whose cash inflows exceed outflows

15. Loanable Funds Theory Supply of Loanable Funds
Households, as a group, are net suppliers of loanable funds
Governments and businesses are net demanders of loanable funds
Suppliers of loanable funds are willing to supply more funds if interest rates are higher
There is a direct relationship between quantity of loanable funds supplied and the interest rate

16. Loanable Funds Theory Supply of Loanable Funds
In the United States, the supply of loanable funds is also influenced by the monetary policy of the Federal Reserve
The Fed controls the amount of reserves held by depository institutions and can influence the amount of savings available for loanable funds

17. Interest
Rate S
Quantity of Loanable Funds

18. Graphic Presentation Interest Rates Quantity of Loanable Funds
Supply of Loanable Funds
Interest
Rates
Demand for Loanable Funds
Quantity of Loanable Funds

19. Loanable Funds Theory Graphic Presentation
When a disequilibrium situation exists, market forces should cause an adjustment in interest rates until equilibrium is achieved
Example: interest rate above equilibrium
Surplus of loanable funds
Rate falls
Quantity supplied reduced, quantity demanded increases until equilibrium

20. Economic Forces That Affect Interest Rates
Economic Growth
Inflation
Money Supply
Budget Deficit
Foreign Flows of Funds

21. Economic Forces That Affect Interest Rates
Economic Growth
Expected impact is an outward shift in the demand schedule without obvious shift in supply
Result is an increase in the equilibrium interest rate

22. Economic Forces That Affect Interest Rates
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

23. Economic Forces That Affect Interest Rates
Money Supply
When the Fed increases the money supply, it increases supply of loanable funds
Places downward pressure on interest rates

24. Economic Forces That Affect Interest Rates
Budget Deficit
Increase in deficit increases the quantity of loanable funds demanded
Demand schedule shifts outward, raising rates
Government is willing to pay whatever is necessary to borrow funds, “crowding out” the private sector

25. Economic Forces That Affect Interest Rates
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