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Chapter 2

Determination of Interest Rates

© 2001 South-Western College Publishing Company

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Relevance of Interest Rate Movements

Interest rate movements affect the values of virtually all securitiesThey have a direct influence on debt instruments

• Bonds, MortgagesThey have an indirect influence on stocks and

exchange rates Interest rates affect the value of financial

institutionsManagers of financial institutions closely monitor

rates

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Loanable Funds Theory

Commonly used to explain interest rate movements

Suggests that market interest rates are determined by the supply and demand for loanable funds

Some sectors of the economy supply loanable funds, other demand loanable funds

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Loanable Funds Theory

Household Demand for Loanable FundsHouseholds 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

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InterestRate

Quantity of Loanable Funds

D

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Loanable Funds Theory

Household Demand for Loanable FundsEvents can cause household borrowing

preferences to change, shifting demand schedule• Example: tax rates are expected to decrease

–Households believe that they can more easily afford future loan payments

–They are willing to borrow more–For any interest rate => greater quantity of

loanable funds demanded => outward shift

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Loanable Funds Theory

Business Demand for Loanable FundsBusinesses demand loanable funds to invest

in assetsQuantity of funds demanded depends on how

many projects to be implemented

• Businesses choose projects by calculating the project’s Net Present Value

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Loanable Funds Theory

Business Demand for Loanable FundsProjects 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

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Loanable Funds Theory

Business Demand for Loanable FundsThere 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

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Loanable Funds Theory

Government Demand for Loanable FundsWhen 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.

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Loanable Funds Theory

Government Demand for Loanable FundsFederal government expenditure and tax

policies are independent of interest ratesGovernment demand for funds is interest-

inelastic

D

InterestRate

Quantity of Loanable Funds

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Loanable Funds Theory

Foreign Demand for Loanable FundsA 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

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Loanable Funds Theory

Aggregate Demand for Loanable FundsThe 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

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Loanable Funds Theory

Supply of Loanable FundsRefers to funds provided to financial markets

by saversThe household sector is the largest supplierLoanable funds are also supplied by

• Governmental units that temporarily have excess funds

• Businesses whose cash inflows exceed outflows

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Loanable Funds Theory

Supply of Loanable FundsHouseholds, as a group, are net suppliers of

loanable fundsGovernments and businesses are net

demanders of loanable fundsSuppliers of loanable funds are willing to

supply more funds if interest rates are higher• There is a direct relationship between

quantity of loanable funds supplied and the interest rate

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Loanable Funds Theory

Supply of Loanable Funds In the United States, the supply of loanable

funds is also influenced by the monetary policy of the Federal Reserve

• The Fed controls the amount of reserves held by depository institutions and can influence the amount of savings available for loanable funds

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InterestRate

Quantity of Loanable Funds

S

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Graphic Presentation

Demand for Loanable Funds

Supply of Loanable FundsInterest Rates

Quantity of Loanable Funds

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Loanable Funds Theory

Graphic PresentationWhen 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

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Economic Forces That Affect Interest Rates

Economic Growth Inflation Money Supply Budget Deficit Foreign Flows of Funds

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Economic Forces That Affect Interest Rates

Economic GrowthExpected impact is an outward shift in the

demand schedule without obvious shift in supply

Result is an increase in the equilibrium interest rate

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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

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Economic Forces That Affect Interest Rates

Money SupplyWhen the Fed increases the money supply, it

increases supply of loanable fundsPlaces downward pressure on interest rates

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Economic Forces That Affect Interest Rates

Budget Deficit Increase in deficit increases the quantity of

loanable funds demandedDemand schedule shifts outward, raising

ratesGovernment is willing to pay whatever is

necessary to borrow funds, “crowding out” the private sector

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Economic Forces That Affect Interest Rates

Foreign Flows In recent years there has been massive

flows between countriesDriven by large institutional investors

seeking high returnsThey invest where interest rates are high

and currencies are not expected to weakenThese flows affect the supply of funds

available in each country