CHAPTER 5
Interest Rate
Determination
©Thomson/South-Western 2006
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Interest Rates
 Interest rates are important because they affect:
 the level of consumer expenditures on durable goods;
 investment expenditures on plant, equipment, and
technology;
 the way that wealth is redistributed between borrowers
and lenders;
 the prices of such key financial assets as stocks, bonds,
and foreign currencies;
 the monthly payments on households’ car loans and home
mortgages, and
 income earned by households on savings accounts,
certificates of deposit, various types of bonds, and money
market mutual fund shares.
 For our purposes, “interest rate” and “yield” are used
interchangeably.
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Real and Nominal Interest Rates
 The nominal interest rate is the stated
interest rate, unadjusted for inflation.
 The real interest rate is the nominal interest
rate adjusted for inflation.
 The real interest rate is the actual interest rate
that would prevail in a hypothetical world of
zero inflation.
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Present Value: Interest Rates
And Security Prices
 Present Value (PV), Interest Rates(i), and Securities
Prices interrelate.
 The present value is the discounted value of a
payment (or stream of payments) to be received at
some point in the future.
 Simple one-year present value: PV = FV / (1+i)
 The future value is the interest-adjusted value of a
payment (or payments) to be made now (or in the
future) at some point in the future.
 Simple one-year future value: FV = PV (1+ i)
 The price of any security is the present value at a
given interest rate of the future payments expected
to be made by the security issuer
 PV (or price) = R1/(1+i) + R2 / (1+i)2 + R3 / (1+i)3 + … + Rn / (1+i)n
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Fig 5-1
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Interest Rates and Security
Prices
 Interest rates and bond (or any debt instrument) prices are
inversely related.
 Interest rate increases decrease bond prices (PV).
 Interest rate decreases increase bond prices (PV).
 At interest rate, i, a bond that pays F at maturity with coupon
payments C1, C2, C3, …,Cn is worth
 PV = C1/(1+i) + C2/(1+i)2 + C3(1+i)3 + … + (Cn+ F) / (1+i)n
 Suppose a 5%, 5-year bond pays $1000 at maturity with
annual coupons of $50.
 If interest rates rise to 6% then price falls to $965.34
 $50/1.06 + $50/(1.06)2 + $50/(1.06)3 + ($50 + $1,000) /
(1.06)4
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The Loanable Funds Model Of
Interest Rates
 Economists and financial analysts use the
loanable funds model to forecast interest
rates.
 The interest rate is the price paid for the right to
borrow and use loanable funds.
 Borrowers demand funds,
 Savers supply funds.
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Individual Sources of Supply and Demand
for Loanable Funds in the United States
 Sources of Supply
 personal saving
 business saving
 government budget surplus
 bank loans
 foreign lending in the U.S.
 Sources of Demand
 household credit purchases
 business investment spending
 government budget deficit
 foreign borrowing in the U.S.
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Figure 5-2
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The Loanable Funds Model
 The interest rate:
 is the reward for saving;
 works to counteract the human trait of time preference.
 Supply slopes upward.
 Household saving is relatively insensitive to the interest rate.
 Bank lending varies directly with the interest rate because profitmaximizing banks more aggressively seek out and grant loans as rates
rise.
 Holding foreign interest rates constant, an increase in U.S. rates attracts
additional funds to U.S. financial markets from abroad.
 Demand slopes downward.
 Lower car/home/furniture loan rates reduce monthly payments, thereby
increasing these items’ affordability.
 Lower rates induce investment in plant, equipment, inventories, and nonresidential real estate.
 Lower interest rates in the United States induce foreigners to step up
borrowing in the U.S.
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Factors Shifting Supply and
Demand for Loanable Funds
 Inflation Expectations
 Federal Reserve Policy
 The Business Cycle
 Federal Budget Deficits (Surpluses)
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Inflation Expectations
 Interest rates rise in periods during which people
expect inflation to increase.
 Interest rates typically fall when people expect
inflation to decline.
 The loanable funds framework can easily explain this:
 People are less willing to lend funds because they
expect the real value of the principal loaned out to
erode more rapidly if inflation increases.
 People are much more willing to borrow because
they expect the real value of the debt incurred to
fall more rapidly as inflation rises.
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The Fisher Hypothesis
 A formula linking nominal (actual) interest rates and
expected inflation:
 i = r + e
 e represents the expected inflation rate
  is the extent to which nominal interest rates adjust to each one
percentage-point increase in the expected inflation rate
 The Fisher Hypothesis:
 strong form: =1 inflation neutrality
 weak form: >0
 Economists agree that inflation expectations powerfully influence
the level of interest rates, especially long-term rates.
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The Fundamental Forces Driving
Real Interest Rates
 Marginal productivity of capital:
 rate of return expected by firms from purchase of
an additional unit of capital goods
 Rate of time preference:
 extent to which people prefer present goods over
future goods
 Federal Reserve policies
 The federal government budget
 Business cycle conditions
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Empirical Evidence on the Fisher
Hypothesis
 Empirical research indicates that the
sensitivity of interest rates to inflation appears
to have increased sharply in the post-World
War II era.
 Before the 1940s, financial markets do not appear
to have responded to inflation.
 In the past 50 years, interest rates have exhibited
a definite sensitivity to the outlook for inflation.
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Federal Reserve Policy
 To stimulate the economy, the Fed implements measures
that:
 encourage banks to expand loans,
 thereby boosting the money supply moving the
supply curve of loanable funds rightward, which
 reduces interest rates.
 To restrain economic activity, the Fed implements actions
that:
 force banks to reduce their lending,
 thereby curtailing the money supply, moving the
supply curve of loanable funds leftward and thus
 driving up interest rates.
 The Federal Reserve has considerably more direct influence
on short-term interest rates than on long-term rates.
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The Business Cycle
 Interest rates have historically been strongly
pro-cyclical:
 rising during the expansion phase of the business
cycle and
 falling during periods of economic contraction.
 This pattern is most evident in short-term interest
rates.
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Federal Budget Deficits (or
Surpluses)
 Intuitively, an increase in the federal budget deficit should raise interest
rates.
 An increase in borrowing by the federal government implies a rightward shift
in the demand curve for loanable funds.
 Most economists agree that deficits lead to higher interest rates.
 Some disagree and argue:
 that the size of the U.S. deficit is small in relation to the total pool of
worldwide financial capital, and
 that a relationship between the federal budget deficit and saving
behavior of individuals interferes with any such direct relationship
between the size of the budget deficit and interest rates.
 The Ricardian Equivalence proposition suggests that people will offset
deficits with greater savings to pay future taxes.
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Major Interest Rate Movements,
1960-2003
 1960-1965
 Low inflation, low bond yields.
 1965-1981
 Vietnam(66-69), oil price shocks (73-79), rapid inflation (78-80),
 Fed policy increased interest rates to eradicate inflation (80-81)
 1980-2003
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inflation fell, expected inflation Fell
worldwide recession (81-83)
moderate inflation (82-90)
sluggish recovery from 1990 recession->low short term interest rates
low inflation (91-2000)
low long and short term rates (00-03)
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Real Interest Rates: Ex Ante vs
Ex Post
 Expected or ex ante real rate
 r ex ante = i - e
 Realized or ex post real rate
 r ex post = i - 
 The expected or ex ante real interest rate is of
CRITICAL importance because investors act
upon this information.
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Two Measures of Ex Ante Real
Interest Rates
 Before Tax
 r = i - e
 After Tax
 rat = i (1-t) - e
 Where t is the marginal income tax rate
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The Historical Behavior of
Expected Real Interest Rates
 The expected real interest rate is not constant
over time.
 1970s low
 1980s high
 1990s intermediate
 2000-2004 very low (some negative)
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The High Rates of the 1980s
 The Fed maintained tight money policies in
1980-81.
 Large federal budget deficits emerged after
1981 (tax cuts and defense buildup).
 Pro-business policies (cuts in business taxes,
deregulatory actions), increased the expected
returns from capital expenditures, boosting
demand for funds by business.
 Lower real energy prices increased demand
for energy intensive capital goods.
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 1970s
Low Real Rates of the 1970s
and 2000s
 stimulative monetary policy
 expected returns from capital goods were low
 small budget deficits
 1995-2000
 technological innovations in information systems,
telecommunications, and other areas led to a sharp increase in the
expected returns from capital
 major swing from large federal budget deficits to large surpluses
 relatively low inflation made possible by surging productivity and a
strong U.S. dollar internationally
 stimulative monetary policy
 2001-2004
 stimulative monetary policy
 recession
 low business and consumer confidence
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