1. Determination of Interest Rates2
© 2003 South-Western/Thomson Learning

2. Chapter Objectives
Explain Loanable Funds Theory of Interest Rate Determination
Identify Major Factors Affecting the Level of Interest Rates
Explain How to Forecast Interest Rates

3. Relevance of Interest Rate Movements
Changes in interest rates impact the real economy
Investment spending
Interest sensitive consumer spending such as housing
Interest rate changes affect the values of all securities
Security prices vary inversely with interest rates
Varying interest rates impact retirement funds and retirement income
Interest rates changes impact the value of financial institutions
Managers of financial institutions closely monitor rates
Interest rate risk is a major risk impacting financial institutions

4. Loanable Funds Theory of Interest Rate Determination
Theory of how the general level of interest rates are determined
Explains how economic and other factors influence interest rate changes
Interest rates determined by demand and supply for loanable funds

5. Loanable Funds Theory, cont.
Demand = borrowers, issuers of securities, deficit spending unit
Supply = lenders, financial investors, buyers of securities, surplus spending unit
Assume economy divided into sectors
Slope of demand/supply curves related to elasticity or sensitivity of interest rates

6. Sectors of the Economy
Household Sector--Usually a net supplier of loanable funds
Business Sector—Usually a net demander in growth periods
Government Sectors
States—Borrow for capital projects
Federal—Borrow for capital projects and deficit spending
Foreign Sectors—Net supplier since early 1980’s

7. Demand for Loanable Funds
Sum of sector demand (quantity) at varying levels of interest rates
Sector cash receipts in period less than outlays = borrower
Quantity demanded inversely related to interest rates
Variables other than interest rate changes cause shift in demand curve

8. Demand for Loanable Funds
Interest
Rate
Quantity of Loanable Funds

9. Household Demand for Loanable Funds
Loanable Funds Theory
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
Household Demand for Loanable Funds

10. Business Demand for Loanable Funds
Loanable Funds Theory
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
Select all projects with +NPV’s
Business Demand for Loanable Funds

11. Business Demand for Loanable Funds
Loanable Funds Theory
Net Present Value is calculated as follows:
Business Demand for Loanable Funds 
CFt
(1 + k)t
t = 1 n
–INV +
NPV =

12. Business Demand for Loanable Funds
Loanable Funds Theory
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
Business Demand for Loanable Funds

13. Business Demand for Loanable Funds
Loanable Funds Theory
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
Business Demand for Loanable Funds

14. Government Demand for Loanable Funds
Loanable Funds Theory
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.
Government Demand for Loanable Funds

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

16. Foreign Demand for Loanable Funds
Loanable Funds Theory
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
Foreign Demand for Loanable Funds

17. Aggregate Demand for Loanable Funds
Loanable Funds Theory
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
Aggregate Demand for Loanable Funds

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

19. Supply of Loanable Funds
Sum of sector supply (quantity) at varying levels of interest rates
Sector cash receipts in period greater than outlays—lender
Quantity supplied directly related to interest rates
Variables other than interest rate changes causes a shift in the supply curve

20. Interest
Rate S
Quantity of Loanable Funds

21. Loanable Funds Theory Equilibrium Interest Rate Aggregate Demand
DA = Dh + Db + Dg + Dm + Df
Aggregate Supply
SA = Sh + Sb + Sg + Sm + Sf
In equilibrium, DA = SA

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

23. 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

24. General Equilibrium Interest Rate
Means of explaining how economic factors affect interest rate levels
Interest rate level where quantity of aggregate loanable funds demanded = supply
Surplus and shortage conditions
Surplus- Quantity demanded < quantity supplied followed by market interest rate decreases
ShortageGovernment interest rate ceilings below market interest rates

25. Interest Rate Changes
+ Directly related to level of economic activity or growth rate of economic activity
+ Directly related to expected inflation
– Inversely related to rates of money supply changes

26. Economic Forces That Affect Interest Rates
Economic Growth
Expected impact is an outward shift in the demand schedule without obvious shift in supply
New technological applications with +NPV’s
Result is an increase in the equilibrium interest rate

27. Economic Forces That Affect Interest Rates: The Fisher Effect
Lenders want to be compensated for expected loss of purchasing power (inflation) when they lend
Nominal Interest Rates = Sum of real rate plus expected rate of inflation,
Expected Real Rate (ex ante) = expected increase in purchasing power in period
Realized Real Rate (ex post) = nominal rates less actual rate of inflation in period i E I n r = + ( )

28. Economic Forces That Affect Interest Rates
Inflation
The Fisher Effect
Nominal Interest Rates = Sum of Real Rate plus Expected Rate of Inflation in = ir +
E(I)

29. Figure 2.12 here Y e a r - 5 1 2 A n u l i z d R I t s f o T B 9 6 4 81 2 A n u l i z d R I t s f o T B 9 6 4 8 7 3

30. 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

31. 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

32. Economic Forces That Affect Interest Rates
Federal Government 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

33. 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
Investors seek the highest real after-tax, exchange rate adjusted rate of return around the world

34. Forecasting Interest Rates
Attempts to forecast demand/supply shifts
Forecast economic sector activity and impact upon demand/supply of loanable funds
Forecast incremental effects on interest rates
Forecasting interest rates has been difficult

35. Summary: Key Factors Impacting Interest Rates Over Time
Economic Growth—Increased growth; increased demand for funds; interest rates increase
Expected inflation--security prices fall; interest rates increase
Government budgets
Deficit—increase borrowing; security prices fall, interest rates increase
Surplus—decreased borrowing; security prices increase; interest rates decrease
Increased foreign supply of loanable funds—security prices increase; interest rates decrease