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Ch-2, Determination of Intt Rates

The document discusses factors that influence interest rate movements, including demand for and supply of loanable funds. It explains that interest rates are determined by the equilibrium of aggregate demand and supply of loanable funds. Demand comes from households, businesses, governments, and foreign entities, while supply comes from savers. Economic forces like growth, inflation, and monetary policy can cause shifts in demand or supply and thereby affect the equilibrium interest rate.

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79 views19 pages

Ch-2, Determination of Intt Rates

The document discusses factors that influence interest rate movements, including demand for and supply of loanable funds. It explains that interest rates are determined by the equilibrium of aggregate demand and supply of loanable funds. Demand comes from households, businesses, governments, and foreign entities, while supply comes from savers. Economic forces like growth, inflation, and monetary policy can cause shifts in demand or supply and thereby affect the equilibrium interest rate.

Uploaded by

AR Rafi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Chapter 2

Determination of Interest Rates


• Interest rate movements have a direct
influence on the market values of debt securities
and indirect influence on equity security values.
• Interest rate movements also affect the value
of most financial institutions.
• Managers of financial institutions anticipate
Interest rate movements so that they can
capitalize on favorable movements or reduce
their risk to unfavorable movements.
Loanable Funds Theory
 Loanable Funds Theory is commonly used
to explain interest rate movements,
suggests that the market interest rate is
determined by the factors that control the
supply of and demand for loanable funds.

 Demand for loanable funds refer to the


borrowing activities of households,
business, and governments.
Household Demand for Loanable Funds

 Households commonly demand loanable


funds to finance housing expenditures, to
purchase automobiles and household
items, which results in installment debts.

 It is generally lower in recessionary


period.
Business Demand for Loanable Funds

 Businesses demand loanable funds to invest in


long-term (fixed) and short term assets.
 Businesses evaluate a project by comparing
the present value of its cash flows to its initial
investment.
 Projects with a positive NPV are accepted.

 The more projects will have positive NPVs,


businesses will need a greater amount of
financing.
 Businesses also invest in short-term assets in
order to support ongoing operations.
 Shifts in demand for Loanable Funds.

 If economic conditions become more


favorable, additional projects will be
acceptable, causing an increased demand for
loanable funds.

 The increase in demand will result in an


outward shift in the demand curve.
Government Demand for
Loanable Funds
 Whenever a government’s planned
expenditures cannot be completely
covered by its incoming revenues from
taxes and other sources, it demands for
loanable funds.
 Government issues treasury securities.
 Government’s demand for funds is interest-
inelastic.
 That is why demand curve is vertical.
Foreign Demand for
Loanable Funds
 The British government may obtain financiang by
issuing British treasury security to U.S. investors.

 A larger quantity of U.S. funds will be demanded


by foreign governments and corporations if their
domestic interest rates are high relative to U.S.
rates.

 If foreign interest rates rise, foreign (UK) firms and


govt. will increase their demand for US funds.
Aggregate Demand for
Loanable Funds

► The aggregate demand for loanable funds


is the sum of the quantities demanded by
the separate sectors at any given interest
rate.
► Ifthe demand schedule of any sector
changes, the aggregate demand schedule
will be affected as well.
Supply of Loanable Funds

► Supply of Loanable funds refer to funds provided


to financial markets by savers.

► The household sector is the largest supplier.

► Suppliers of Loanable funds are willing to supply


more funds if the interest rate is higher, other
things being equal.
Aggregate Supply of Loanable funds

 The Aggregate Supply schedule of


Loanable funds represents the combination of
all sector supply schedule.

 The quantity of loanable funds demanded is


more elastic, meaning more sensitive to the
interest rates, rather than the quantity of
loanable funds supplied.

 Supply curve can shift in or out.


Equilibrium Interest Rate

 Algebric Presentation
 DA = Dh + Db + Dg + Dm + Df
 S A = Sh + S b + S g + S m + Sf
 In equilibrium, DA = SA
 Interest rate should rise when DA > SA and fall
when DA < SA.

 Graphic Presentation
Economic Forces That Affect
Interest Rates
 Impact of economic growth on Interest rates.

 When businesses anticipate that economic conditions


will improve, they revise upward the cash flows expected
for various projects under consideration. Consequently
businesses identify more projects and they are willing to
borrow more funds. That reflects an outward shift in the
demand schedule to the right. This causes an increase
in the equilibrium interest rate to i2

 Securities are rationally priced.


Economic Forces That Affect
Interest Rates
 Impact of economic slowdown on Interest rates.

 When businesses anticipate that economic conditions


will improve, they revise upward the cash flows
expected for various projects under consideration.
Consequently businesses identify more projects and
they are willing to borrow more funds. That reflects an
outward shift in the demand schedule to the right. This
causes an increase in the equilibrium interest rate to i 2

 Securities are rationally priced.


Economic Forces That Affect Interest Rates
 Impact of Inflation on Interest Rates.
 When inflation rate increases, households may reduce their savings
at any interest rate so that they can make the same amount of
purchases. This will reflect an inward shift in the supply curve.
 In addition households and businesses may be willing to borrow
more funds so that they can purchase same amount of products.
Supply curve also shifts to the right.
 The new equilibrium interest rate is higher.

 Securities are rationally priced.


Economic Forces That Affect Interest Rates

Fisher Effect
 i = E(INF) + i
R
When the inflation rate is higher than anticipated,
the real interest rate is relatively lower.
Borrowers benefit because they were able to
borrow at a lower nominal interest rate.
When the inflation rate is lower than anticipated,
the real interest rate is relatively high and
borrowers are adversely affected.
 Impact of Monetary Policy on Interest
rates.
 When the central bank increases the
money supply, it increases the the supply
of loanable funds, which places downward
pressure on interest rates.
 When the central bank reduces the money
supply, it reduces the the supply of
loanable funds, which places upward
pressure on interest rates.
 Impact of Budget Deficit on Interest
rates.
 A higher budget deficit increases the
quantity of loanable funds demanded,
causing an outward shift in the demand
schedule. Assuming no offsetting increase
in the supply schedule, interest rate will
rise.
Impact of Foreign flow of funds on
Interest rates.
 The actual positions of supply and demand
schedules vary among currencies. The demand
and supply cuves are farther to the right for the
dollar than for the Brazilian dollar. Because the
US economy is much larger than Brazil’s
economy.
 The equilibrium interest rate is much higher for
the Brazilian Real than for the dollar.
Forecasting Interest Rates
 ND = DA - S A
=(Dh +Db +Dg +Df) – (Sh +Sb +Sg +Sf )

 If positive, it will be corrected by upward adjustment in


interest rates

 If negative, it will be corrected by downward adjustment in


interest rates

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