THE LEVEL OF INTEREST RATES

2 What are Interest Rates? Rental price for money. Penalty to borrowers for consuming before earning. Reward to savers for postponing consumption. Expressed in terms of annual rates. As with any price, interest rates serve to allocate resources.

3 The Real Rate of Interest Producers seek financing for real assets. Expected ROI is upper limit on interest rate producers can pay for financing. Savers require compensation for deferring consumption. Time value of consumption is lower limit on interest rate at which savers will provide financing. Real rate occurs at equilibrium between desired real investment and desired saving.

4 Determinants of the Real Rate of Interest

5 Loanable Funds Theory ( Neo Classical theory) Supply of loanable funds— All sources of funds available to invest in financial claims Demand for loanable funds— All uses of funds raised from issuing financial claims Equilibrium interest rate

6 Supply of loanable funds— All sources of funds available to invest in financial claims: Consumer savings Business savings Government budget surpluses Central Bank Action

7 Demand for Loanable Funds All uses of funds raised from issuing financial claims: Consumer credit purchases Business investment Government budget deficits

8 Equilibrium Interest Rate If competitive forces operate in financial sector, laws of supply and demand will bring rates into equilibrium. Equilibrium is temporary or dynamic: Any force that shifts supply or demand will tend to change interest rates.

9 Loanable Funds Theory

10 Loanable Funds Theory

11 Loanable Funds Theory

12 Loanable Funds Theory

Classical Interest Rate Theory Real i rate S & I S I i S’ i’ If the desire to save rises, interest rates fall and investment increases.

Limitations of Classical Theory Interest rate is indeterminate Unless savings and investments are determined, Interest rate remains indeterminate 14

Keynesian Theory of Interest, Savings and Investment The interest rate is a monetary phenomenon determined in the money market Savings primarily a function of income and not very responsive to the interest rate Investment determined by the interest rate but, more importantly, by the state of business expectations The amount people wish to save at full employment levels of income may not equal the level of investment planned by businesses

Keynesian Theory of Interest, Savings and Investment i Money i rate i is determined in the money market Both S and I are interest inelastic I can shift in due to adverse expectations so That at i FE levels of S > I I S at FE I’

Keynesian Critique of Classical Postulates: III Classical Theory of the Demand for Money Demand for money for transactions purposes Keynesian Theory of the Demand For Money Demand for money for transactions and as an asset At certain times people may rather hold their assets as money than as stocks or bonds

Money and Interest Rates Savings depend on income but there is still a choice of how to hold ones savings Desire to hold bonds vs money Liquidity preference Transactions demand for money Precautionary demand for money Speculative demand for money Speculative demand is an asset demand Will hold money if bond prices expected to fall and bonds if bond prices expected to rise

transactions motive people hold money to buy stuff as income rises, Md rises

precautionary motive people hold money for emergencies car breakdown job loss Md rises with income

speculative motive suppose store wealth as money or bonds high interest rates bonds more attractive, hold less money Md negatively related to interest rate

Money and Interest Rates Will expect bond prices to fall if interest rates are expected to rise and vice versa Different people may have different expectations but when interest rates are at very low levels most people will expect a rise rather than another fall and will want to hold money rather than bonds

Limitations of Keynes theory Interest cannot be know unless total demand for money is known 23