Determination of Interest Rates 2 © 2003 South-Western/Thomson Learning

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

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

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

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

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

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

Demand for Loanable Funds Interest Rate Quantity of Loanable Funds

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

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

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 =

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

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

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

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

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

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

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

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

Interest Rate S Quantity of Loanable Funds

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

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

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

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

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

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

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 = + ( )

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)

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 8 1 2 A n u l i z d R I t s f o T B 9 6 4 8 7 3

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

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

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

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

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

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