Chapter 8
Interest Rates
© 2014 John Wiley and Sons
Supply and Demand for
Loanable Funds


Basic Interest Rate Concepts:
Interest Rate:
Price that equates the demand for
and supply of loanable funds
Role of Financial Markets:
Interest rates are determined by the
supply and demand for loanable
funds in financial markets
2
Interest Rate Determination in the
Financial Markets
A
B
S1
S1
6%
5%
D1
D1
Quantity of Loanable Funds
S2
D2
Quantity of Loanable Funds
S1
S2
7%
S1
6%
D1
Quantity of Loanable Funds
C
D3 D1
Quantity of Loanable Funds
D
3
Loanable Funds Theory

Loanable Funds Theory Definition:
States that interest rates are a
function of the supply of and demand
for loanable funds
4
Factors Affecting the Supply of
Loanable Funds

Volume of Savings

Major factor is the level of national income
Expansion of Deposits by Depository
Institutions

Amount of short-term credit available
depends on lending policies of depository
institutions and the Fed
Liquidity Attitude
Refers to how lenders see the future
5
Determinants of Market
Interest Rates



Nominal Interest Rate (r): Interest rate
that is observed in the marketplace
Basic Equation:
r = RR + IP + DRP
Real Rate of Interest (RR): Interest rate
on a risk-free debt instrument when no
inflation is expected
– Interest rate on a debt instrument with no
default, maturity, or liquidity risks (Treasury
securities are the closest example)
6
Determinants of Market
Interest Rates (continued)


Inflation Premium (IP):
Average inflation rate expected over
the life of the security
Default Risk Premium (DRP):
Compensation for the possibility of
the borrower’s failure to pay interest
and/or principal when due
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Determinants of Market
Interest Rates (concluded)



Basic Equation Expanded:
r = RR + IP + DRP + MRP + LP
Maturity Risk Premium (MRP):
Compensation expected by investors
due to interest rate risk on debt
instruments with longer maturities
Liquidity Premium (LP):
Compensation for securities that
cannot easily be converted to cash
without major price discounts
8
Two Types of U.S. Government
Debt Obligations

Marketable Government Securities:
Securities that may be bought and sold
through the usual market channels

Nonmarketable Government
Securities:
Issues that cannot be transferred between
persons or institutions but must be
redeemed with the U.S. government
9
Types of U.S. Treasury Debt
Obligations

Treasury Bills:
Obligations that bear the shortest (up to
one year) original maturities

Treasury Notes:
Obligations issued with maturities of one
to ten years

Treasury Bonds:
Obligations issued with maturities usually
over ten years and up to thirty years
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Term or Maturity Structure of
Interest Rates

Term Structure:
Relationship between interest rates or
yields and the time to maturity for debt
instruments of comparable quality

Yield Curve:
Graphic presentation of the term
structure of interest rates at a given
point in time
11
Term Structure Extremes for U.S.
Treasury Securities
Maturity
March 1980
Dec. 2012
6 months
15.0%
0.11%
1 year
14.0%
0.16%
5 years
13.5%
0.72%
10 years
12.8%
1.78%
20 years
12.5%
2.54%
30 years
12.3%
2.95%
12
Three Term Structure Theories


Expectations Theory:
Shape of the yield curve indicates
investor expectations about future
inflation rates
Liquidity Preference Theory:
Investors are willing to accept lower
interest rates on short-term debt
securities which provide greater
liquidity and less interest rate risk
13
Three Term Structure Theories
(continued)

Market Segmentation Theory:
Interest rates may differ because
securities of different maturities are
not perfect substitutes for each other
14
Inflation Premiums and
Price Movements

Inflation:
Occurs when an increase in the price
of goods or services is not offset by
an increase in quality
15
Types of Inflation


Cost-Push Inflation:
Occurs when prices are raised to
cover rising production costs, such
as wages
Demand-Pull Inflation:
Occurs during economic expansions
when demand for goods and
services is greater than supply
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Types of Inflation (continued)


Speculative Inflation:
Caused by the expectation that
prices will continue to rise, resulting
in increased buying to avoid even
higher future prices
Administrative Inflation:
The tendency of prices, aided by
union-corporation contracts, to rise
during economic expansion and to
resist declines during recessions
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Web Links


www.stlouisfed.org
www.whitehouse.gov/cea
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