004 c4 determination of interest rates

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TOPIC 3

DETERMINING MARKET

INTEREST RATES



2

DETERMINING THE LEVELOF INTEREST RATES

•Interest rate is the price of borrowing money. The level dependson supply and demand for loanable funds

•2 ways to assess the demand/supply for loanable funds:

•Bond market perspective

•Loanable fund perspective



Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 6-3

Supply of Loanable Funds or

Demand for Bonds by Lenders




Demand for Loanable Funds or

Supply of Bonds by Borrowers




Equilibrium in Markets for Bonds and

Loanable Funds



6

Loanable Funds Theory

Market interest rate is determined by the factors that control

supply of and demand for loanable funds.



7

Demand for Loanable Funds

1. Household demand for loanable funds

-For purchases of house, automobiles, household items

-Inverse relationship between the interest rate and the quantity of loanable

funds demanded.-HHs demand greater qtty of loanable funds at lower rates of interest

2. Business demand for loanable funds

-Depends on number of business projects to be implemented.

-More demand at lower interest rates-cost of borrowing

3. Government demand for loanable funds

-Interest inelastic: insensitive to interest rates.

-Expenditures and tax policies are independent of the level of interest rates



8

Demand for Loanable Funds

4. Foreign demand for loanable funds

-A country’s demand for foreign funds depends on the interest rate

differential between the two.

-The greater the differential, the greater the demand for foreign funds.-The quantity of U.S. loanable funds demanded by foreign governments will

be inversely related to U.S. interest rates.

5. Aggregate demand for loanable funds




Demand for Loanable Funds or

Supply of Bonds by Borrowers



10

Supply of Loanable Funds

1. Households are largest supplier, but some supplied by

government units.

2. More supply at higher interest rates.

3. Supply by buying securities.

4. Effects of the Fed: By affecting the supply of loanable

funds, Fed’s monetary policy affects interest rates.

5. Aggregate supply of funds




Supply of Loanable Funds or

Demand for Bonds by Lenders



12

Equilibrium Interest Rate

1. Aggregate Demand for funds ( D A) D A = Dh + Db + D g + Dm + D f

Dh = household demand for loanable funds

Db = business demand for loanable funds

D g = federal government demand for loanable funds Dm = municipal government demand for loanable funds

D f = foreign demand for loanable funds

2. Aggregate Supply of funds (S A)S A = S h + S b + S g + S m + S f

S h = household supply for loanable fundsS b = business supply for loanable funds

S g = federal government supply for loanable funds

S m = municipal government supply for loanable funds

S f = foreign supply for loanable funds




Equilibrium in Markets for Bonds and

Loanable Funds



6-14

Explaining Changes

in Equilibrium Interest Rates

• Factors affecting change in supply and demand

for loanable funds

• The underlying economic forces that cause achanges in SS and DD for loanable funds

1. Economic conditions

2. Inflation3. Monetary policy

4. Budget deficit

5. Foreign flows of funds



Shifts in the Demand Curve



Shifts in the Supply Curve

Figure 4.4 Shift in the Supply Curve for Bonds



Impact of Economic Growthon Interest Rates

1. Wealth

Economy , wealth , B d , B d shifts out to right

2. Profitability of Investment OpportunitiesBusiness cycle expansion, investment opportunities , B s , Bs

shifts out to right

Economic growth puts upward pressure on interest rates

Economic slowdown puts downward pressure on interest rates



Business Cycle Expansion



Evidence on Business Cycles andInterest Rates

Business Cycle and Interest Rates (Three-Month Treasury Bills), 1951 – 2004



20

Impact of Inflation onInterest Rates

Fisher hypothesis: the relationship between interest rate andexpected inflation

Nominal interest rate compensate savers in two ways: (i)compensate savers reduced purchasing power, (ii) Provide an

additional premiun for savers to forgo current consumption in = ir + expected inflation

So,

The real interest rate is the difference between nominalinterest rate minus expected inflation. Real interest rate more accurately reflects true cost of borrowing

When real rate is low, greater incentives to borrow and less to lend

Real interest rate more accurately the true return to saving

ir

i e



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Distinction Between Realand Nominal Interest Rates cont.)

Economy A. If i = 5% and π e = 0% then

ir

5% 0% 5%

ir

10% 20% 10%

Economy B. If i = 10% and πe = 20% then



22

Fisher Effect: Impact of Inflationon Interest Rates

If π e 1. Relative R e , expected return on bond fall, B d shifts in

to left2. Cost of borrowing is lower, B s , B s shifts out to right3. P , i



Changes in π e : The Fisher Effect



24

Summary of the Fisher Effect

1. If expected inflation rises from 5% to 10%, the expectedreturn on bonds relative to real assets falls and, as aresult, the demand for bonds falls

2. The rise in expected inflation also means that the realcost of borrowing has declined, causing the quantity ofbonds supplied to increase

3. When the demand for bonds falls and the quantity ofbonds supplied increases, the equilibrium bond price falls

4. Since the bond price is negatively related to the interestrate, this means that the interest rate will rise



Expected Inflation and Interest Rates (Three-Month Treasury Bills),–

Evidence on the Fisher Effect in the US



Impact of Monetary Policy onInterest Rates

1. Central banks (CBs) can affect the supply on loanablefunds – When CBs increase money supply, it increases the supply of

loanable funds, placing downward pressure on interest rates

– When CBs decrease money supply, it decreases the supply of loanablefunds, placing upward pressure on interest rates

Figure 4.4 Shift in the Supply Curve for Bonds



Impact of Budget Deficit onInterest Rates

1. More expenditures than tax revenue, budget deficitincreases

2. Government demand loanable funds

3. Increases the demand for quantity of loanable fundsdemanded

4. Government ActivitiesDeficits , B s , B s shifts out to right



Impact of Foreign Flows ofFunds on Interest Rates

1. Interest rates also determined by demand for fundsdenominated in that currency and supply of fundsavailable in that currency

2. Massive flows of funds between countries-give impact onsupply of loanable funds, affecting interest rates

3. Shifts in supply are driven by large institutional investorsseeking for high returns on their investments

004 c4 determination of interest rates

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