1. DETERMINATION OF INTEREST RATES OBJECTIVES 1. To explain the Loanable Funds Theory of interest rate determination 2. To identify the major factors affecting the level of interest rates 3. To discuss the Fed’s monetary policy tools

2. 2 LOANABLE FUNDS THEORY (LFT) u One of several theories of how the general level of interest rates is determined u Interest rates determined by demand and supply for loanable funds u However, as economic and other factors also influence the demand and/or supply level they do impact on interest rate

3. 3 DEMAND FOR LOANABLE FUNDS u Households borrow for consumption (auto, mortgage, etc) u Businesses borrow to invest in plant and machinery u Governments borrow to cover budget deficits (arising from expenditure exceeding revenues) u Foreign governments and businesses borrow in larger, efficient U.S. financial markets, with lower rates u Government demand is interest inelastic, but all other demand curves (on aggregate) slope downwards u Are all components of aggregate consumer spending sensitive to interest rates?

4. 4 SUPPLY OF LOANABLE FUNDS u Households are the major suppliers of funds u Households save from their income to increase future consumption u Rate of savings depends on their preferences for current vs. future consumption, level of income, amount of wealth, and interest rates u But is it always the case that higher interest rates lead to increased savings; i.e., does the supply curve have to slope upward? u Substitution Effect vs. Income Effect u Businesses also invest (loan) funds temporarily, but do interest rates influence the amount they save (retain)?

5. 4 SUPPLY OF LOANABLE FUNDS u Government (municipalities, agencies) may also supply funds temporarily u Federal Reserve’s monetary policy may increase money supply - to lower interest rates and improve economy u Does increasing money supply always cause lower rates? u Foreign governments and households are net suppliers to the U.S. - induced by interest rate differentials u Overseas inflows are also influenced by expected changes in the exchange rate

6. 5 GENERAL EQUILIBRIUM INTEREST RATE u Equilibrium interest rate is that rate at which the quantity of aggregate loanable funds demanded is equal to the aggregate supply of loanable funds u Means of explaining how economic factors affect interest rate levels. How? u Surplus and shortage conditions impact on the equilibrium interest rate

7. 6 INTEREST RATE DETERMINATION Demand for Loanable Funds Supply of Loanable Funds Interest Rates Quantity of Loanable Funds

8. 7 OTHER FACTORS AFFECTING RATES u Changes in demand/supply of loanable funds due to level of economic activity 1. Increase in demand by businesses due to optimistic economic projections leads to increased interest rates if there is no offsetting increase in supply 2. Economic slowdown leads to a decrease in demand for loanable funds by firms => Supply may increase as workers save more in expectation of worse times. Therefore, interest rates are likely to fall => Supply may increase as workers save more in expectation of worse times. Therefore, interest rates are likely to fall

9. 8 FACTORS AFFECTING INTEREST RATES  Inflation and the FISHER Effect 1. Lenders want to be compensated for loss of purchasing power (inflation) 2. Expected increase in inflation leads to higher interest rates next period 3. Nominal interest rates  real interest rate + expected rate of inflation

10. 9 FACTORS AFFECTING INTEREST RATES u Increased Federal Government Deficit 1. Deficit arises when government expenditure exceeds its revenues 2. Government increases its demand for loanable funds; Demand curve shifts to the right  interest rates rise 3. Supply of funds increases but less than increase in government demand 4. This leads to “crowding out” of other borrowers Deficit spending may improve economy and increase savings, thus partially offsetting interest rate increase Deficit spending may improve economy and increase savings, thus partially offsetting interest rate increase

11. 9 FACTORS AFFECTING INTEREST RATES u Crowding-Out Effect Interest Rates Increase in government borrowingSupply i2i2i2i2 i1i1i1i1 Demand 2 Demand 2 Demand 1 Loanable funds Loanable funds Crowding out Increase in funds Crowding out Increase in funds i1i1

12. 10 FACTORS AFFECTING INTEREST RATES u Influence of Foreign Interest Rates 1. Few remaining segmenting barriers between major money markets 2. Higher (lower) rates in the home market attract (discourage) foreign loanable funds, hence, decreasing (increasing) interest rates in the home market 3. Exposure to currency risk impedes the interest rate equalization across countries Given current economic conditions, characterize the (net) flow of funds between the U.S.A. and Japan Given current economic conditions, characterize the (net) flow of funds between the U.S.A. and Japan

13. 11 FACTORS AFFECTING INTEREST RATES u Federal Reserve Monetary Policy 1. Open market operations affect bank reserves which impacts on Fed funds rates, rates on loanable funds and rates paid on new deposits by financial institutions E.g., Low rates on new deposits force funds to alternative investments. The latter experience reduced interest rates as a result of the increase in supply. 2. Adjusting the discount rate may influence the Fed funds and other market-determined rates. The latter also impact on the discount rate 3. Adjusting the reserve requirement ratio impacts on the supply of loanable funds, hence, general interest rates