chapter 2 determination of interest rates © 2003 south-western/thomson learning
TRANSCRIPT
Chapter ObjectivesChapter 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 MovementsRelevance 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 Loanable Funds Theory of Interest Rate DeterminationDetermination
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.Loanable Funds Theory, cont.
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 EconomySectors 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 FundsDemand 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
Loanable Funds TheoryLoanable Funds Theory
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
Household Demand for Loanable Funds
Loanable Funds TheoryLoanable Funds Theory
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
Business Demand for Loanable Funds
Loanable Funds TheoryLoanable Funds Theory
Net Present Value is calculated as follows:
CFt(1 + k)tt = 1
n
–INV +NPV =
Business Demand for Loanable Funds
Loanable Funds TheoryLoanable Funds Theory
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
Business Demand for Loanable Funds
Loanable Funds TheoryLoanable Funds Theory
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
Business Demand for Loanable Funds
Loanable Funds TheoryLoanable Funds Theory
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.
Government Demand for Loanable Funds
Loanable Funds TheoryLoanable Funds Theory
Federal government expenditure and tax policies are independent of interest rates
Government demand for funds is interest-inelastic
D
InterestRate
Quantity of Loanable Funds
Government Demand for Loanable Funds
Loanable Funds TheoryLoanable Funds Theory
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
Foreign Demand for Loanable Funds
Loanable Funds TheoryLoanable Funds Theory
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
Aggregate Demand for Loanable Funds
Sector Supply of Loanable FundsSector 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 FundsSupply 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
Loanable Funds TheoryLoanable Funds Theory
Equilibrium Interest Rate Aggregate Demand
DA = Dh + Db + Dg + Dm + Df
Aggregate Supply
SA = Sh + Sb + Sg + Sm + Sf
In equilibrium, DA = SA
Demand for Loanable Funds
Supply of Loanable Funds
Interest Rates
Quantity of Loanable Funds
Graphic PresentationGraphic Presentation
Loanable Funds TheoryLoanable 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 RateGeneral 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 ShortageGovernment interest rate ceilings below
market interest rates
Interest Rate ChangesInterest 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 Economic Forces That Affect Interest RatesRates
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 Economic Forces That Affect Interest Rates: The Fisher EffectRates: 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,
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
i E I in r= +( )
Economic Forces That Affect Interest Economic Forces That Affect Interest RatesRates
Inflation The Fisher Effect
Nominal Interest Rates = Sum of Real Rate plus Expected Rate of Inflation
in ir E(I)+=
Figure 2.12 hereFigure 2.12 here
Year
-5
0
5
10
15
20
Annualized
Real
Interest Rate
Annualized
Inflation
Annualized
T-Bill
Rate
199619951994 19991998199719931992199119901989198819871986198519841983198219811980
Economic Forces That Affect Interest Economic Forces That Affect Interest RatesRates 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 Economic Forces That Affect Interest RatesRates
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 Economic Forces That Affect Interest RatesRates
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 Economic Forces That Affect Interest RatesRates
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 RatesForecasting 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 Summary: Key Factors Impacting Interest Rates Over TimeInterest 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