Two Major Causes of Interest Rate Differences I. Differences in interest rates over time due to changes in the macro economy, holding the intrinsic characteristics of the securities constant. II. Differences in interest rates intrinsic to the security, like term and risk, holding macroeconomic variables constant

I. Macroeconomic Influences on Interest Rate Loanable funds framework (Bond’s market framework) Liquidity preference theory

The Loanable Funds theory We use the term “loanable funds market” to describe the arrangements and institutions by which saving of households is made available to borrowers.

Factor income Consumption 1.Leakages must be recycled if total spending is to match full-employment GDP. 2.According to the Classical theory, the loanable funds market acts as a conduit to transfer spending power (S) from households to borrowing units (firms and government units). 3.Saving (S) is the “source” of loanable funds. Saving Net taxes

1.To have a more secure future, to start a business, to finance a child’s education, to satisfy miserliness,... 2.To earn interest. We view interest as the “reward for saving” or the “reward for postponing gratification.”

Value of $1,000 in 3 years at alternative interest rates The opportunity cost of spending now (measured in lost future spending) is positively related to the interest rate.

Saving = Supply of Funds Trillions of Dollars 0 Interest rate 3% 5% Supply of Funds

To finance the acquisition of long-lived capital goods. The rate of interest is the cost of borrowing or the price of loanable funds. The investment demand curve indicates the level of investment spending at various interest rates. As the interest rate decreases, more investment projects become attractive in the assessment of business decision- makers—hence, the investment demand function is downward-sloping with respect to the interest rate.

Investment Demand Trillions of Dollars 0 Interest rate 3% 5% 1.5 Demand for Funds by Business 1.0 A B When the interest rate falls, investment spending and the business borrowing needed to finance it rises.

Public sector borrowing Let G denote public sector (or government) spending for goods and services in a year T is net tax receipts in a year. If G is greater than T, the the public sector has a budget deficit equal to G – T. If T is greater than G, then the public sector has a surplus equal to T – G. If the public sector has a budget deficit, it must borrow.

Public Sector Borrowing in Classica G = $2 trillion T = $1.25 trillion Therefore, Budget Deficit = G – T = $2 trillion - $1.25 trillion = $0.75 trillion % 3% Government Demand for Funds Interest Rate Trillions of Dollars A B

Demand for Loanable Funds (in Trillions)

Interest Rate Trillions of Dollars0 3% 5% Total Demand for Funds

Interest Rate Trillions of Dollars Loanable Funds Market Equilibrium Total Supply of Funds (Saving) Total Demand for Funds (Investment + Deficit) E5%

So long as the loanable funds market “clears,” leakages (Saving) will be offset to injections (investment and government spending).

Firms Government Households Resource Markets Goods Markets Loanable Funds Markets Income ($7 Trillion) Factor Payments ($7 Trillion) Government Spending ($2 Trillion) Investment ($1 Trillion) Consumption ($4 Trillion) Firm Revenues ($7 Trillion) Deficit ($0.75 Trillion Income ($7 Trillion) Saving ($1.75 Trillion) Net Taxes ($1.25 Trillion)

Liquidity Preference Framework The concept was first developed by John Maynard Keynes in his book The General Theory of Employment, Interest and (1936) Liquidity preference theory answers the question that why interest should be paid? Explains determination of the interest rate by the supply and demand for money.

Keynes defined interest as: “INTEREST IS THE REWARD TO SACRIFICE LIQUIDITY” When people lend their money their liquid assets decline, they must be paid for the liquidity the have forgone Liquidity Preference Theory: why do people hold money? Medium of Exchange Unit of Account Store of Value

If we assume that the income to be constant( short period indication ) then Md= f (i) Shows that there is a negative relationship between money demand and interest rate. This relationship is given by liquidity Preference Curve as shown.

Money Supply includes currency notes in circulation, demand deposits, credit money etc is set by the government or monetary authority. Keynes assumed that the supply of money has nothing to do with the interest rate i.e. it remains constant.

Shifts in the demand for money Income effect: a higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right. Price-level effect: a rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right.