Loanable Funds Theory of
Interest Rate Determination
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
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
Loanable Funds Theory
Household Demand for Loanable Funds
 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
 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

Loanable Funds Theory
Business Demand for Loanable Funds
Net Present Value is calculated as follows:
n

CFt
NPV = –INV +
t
(1
+
k)
t=1
Loanable Funds Theory
Business Demand for Loanable Funds
 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

Loanable Funds Theory
Business Demand for Loanable Funds
 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

Loanable Funds Theory
Government Demand for Loanable Funds
 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
 Federal government expenditure and tax policies are
independent of interest rates
 Government demand for funds is interest-inelastic
Interest
Rate
D
Quantity of Loanable Funds
Loanable Funds Theory
Foreign Demand for Loanable Funds
 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
 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
 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 + Df
 Aggregate Supply
SA = Sh + Sb + Sg + Sf
In equilibrium, DA = SA
Graphic Presentation
Interest
Rates
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
 Shortage Government 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,
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
 Inflation
 The Fisher Effect

Nominal Interest Rates = Sum of Real Rate plus Expected Rate of
Inflation
in = ir + E(I)
Figure 2.12 here
20
Annualized
Real
Interest Rate
15
Annualized
Inflation
Annualized
T-Bill
Rate
10
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
 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