The Determination of Interest Rates

I. Determinants of the Interest Rate LevelA. Real Rate of Interest

• Definitions– Interest Rate: The price paid for the use of money.

– Nominal Rate: The interest rate expressed in terms of nominal dollars.

– Real Rate:The interest rate expressed in terms of real dollars.

• Equilibrium Real Rate – Supply of Funds (e.g., propensity of household

to save)

– Demand for Funds (e.g., expected productivity of capital)

B. Macroeconomic Factors

• Economic Growth

• Rate of Inflation(1 + r)(1 + i) = (1 + R),

where

r = real rate,

i = inflation rate, and

R = Nominal rate.

Fisher Equation

R = r + E(i)

The nominal rate equals to the real rate plus the expected rate of inflation.

• Money Supply

• Taxes and Government Spending

R(1-t) - i = (r + i)(1 - t) - i

= r(1 - t) - it.

The real after-tax rate is approximately the after-tax nominal rate minus the rate

of inflation.• Foreign Flow of Funds

C. Microeconomic Factors• Default Risk• Administrative Costs • Maturity• Liquidity• Special Provisions (Callability, Convertibility)

II. Theory of Interest Rate

A. Interest Rate Structure

B. Theories• The Liquidity Preference Theory

– Demand for Money

– Supply of Money

• Loanable Funds Theory– Demand for Loanable Funds

– Supply of Loanable funds

III. Interest Rates Over Time

• 1973 Inflation caused by the energy crisis

• 1973-4 Recession

• 1980 Inflation caused by strong economic growth

• 1982 Recession

• 1989 Capital flow caused by a unified Germany

• 1990 Recession

• 1994 Economic Expansion

• 1997 Asian Financial Crisis

IV. Forecasting Interest Rates

ND = DA - SA

= [Dh+ Db+ Dg+ Dm+ Df] - [Sh+ Sb+ Sg+ Sm+ Sf],

where

ND = net demand for loanable funds,

DA = aggregate demand for loanable funds,

SA = aggregate supply of loanable funds,

D = demand, S = supply,

h = household sector, b = business sector,

g = government sector, m= money supply,

f = foreign sector.