CHAPTER
2
Determination of
Interest Rates
© 2003 South-Western/Thomson Learning
Chapter Objectives
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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
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Changes in interest rates impact the real economy
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Interest rate changes affect the values of all securities
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Investment spending
Interest sensitive consumer spending such as housing
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
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Managers of financial institutions closely monitor rates
Interest rate risk is a major risk impacting financial
institutions
Loanable Funds Theory of Interest Rate
Determination
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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.
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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
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Household Sector--Usually a net supplier of
loanable funds
Business Sector—Usually a net demander in
growth periods
Government Sectors
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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
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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
Loanable Funds Theory
Household Demand for Loanable Funds
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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
Loanable Funds Theory
Business Demand for Loanable Funds
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Businesses demand loanable funds to invest in
assets
Quantity of funds demanded depends on how
many projects to be implemented
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Businesses choose projects by calculating the project’s
Net Present Value
Select all projects with +NPV’s
Loanable Funds Theory
Business Demand for Loanable Funds
Net Present Value is calculated as follows:
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NPV = –INV +

t=1
CFt
(1 + k)t
Loanable Funds Theory
Business Demand for Loanable Funds
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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
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Businesses will need a greater amount of financing
Businesses will demand more loanable funds
Loanable Funds Theory
Business Demand for Loanable Funds
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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
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Example: Economic conditions become more favorable
Expected cash flows will increase > more positive NPV
projects > increased demand for loanable funds
Loanable Funds Theory
Government Demand for Loanable Funds
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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.
Loanable Funds Theory
Government Demand for Loanable Funds
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Federal government expenditure and tax policies
are independent of interest rates
Government demand for funds is interest-inelastic
Interest
Rate
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Quantity of Loanable Funds
Loanable Funds Theory
Foreign Demand for Loanable Funds
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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
Loanable Funds Theory
Aggregate Demand for Loanable Funds
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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
Sector Supply of Loanable Funds
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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
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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
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Quantity of Loanable Funds
Loanable Funds Theory
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Equilibrium Interest Rate
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Aggregate Demand
DA = Dh + Db + Dg + Dm + Df
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Aggregate Supply
SA = Sh + Sb + Sg + Sm + Sf
In equilibrium, DA = SA
Graphic Presentation
Interest
Rates
Supply of
Loanable Funds
Demand for
Loanable Funds
Quantity of Loanable Funds
Loanable Funds Theory
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Graphic Presentation
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When a disequilibrium situation exists, market
forces should cause an adjustment in interest
rates until equilibrium is achieved
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Example: interest rate above equilibrium
Surplus of loanable funds
Rate falls
Quantity supplied reduced, quantity demanded
increases until equilibrium
General Equilibrium Interest Rate
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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
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Surplus- Quantity demanded < quantity supplied
followed by market interest rate decreases
ShortageGovernment interest rate ceilings below
market interest rates
Interest Rate Changes
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+ 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
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Economic Growth
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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
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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, i n = E(I ) + i r
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
Economic Forces That Affect Interest
Rates
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Inflation
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The Fisher Effect
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Nominal Interest Rates = Sum of Real Rate plus
Expected Rate of Inflation
in = ir + E(I)
Figure 2.12 here
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Annualized
Real
Interest Rate
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Annualized
Inflation
Annualized
T-Bill
Rate
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5
0
-5
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
Year
Economic Forces That Affect Interest
Rates
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Inflation
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If inflation is expected to increase
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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
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Money Supply
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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
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Federal Government Budget Deficit
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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
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Foreign Flows
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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
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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
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Economic Growth—Increased growth; increased
demand for funds; interest rates increase
Expected inflation--security prices fall; interest rates
increase
Government budgets
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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