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Lecture-3 Determination of Interest Rates

The chapter discusses factors that affect interest rates using the loanable funds theory. It explains that interest rates are determined by the supply of and demand for loanable funds in the market. The demand for loanable funds comes from households, businesses, governments, and foreign entities, and is affected by economic growth, inflation expectations, and fiscal policies. The supply comes from savers like households and is impacted by inflation. Monetary policy by the central bank also influences interest rates by expanding or contracting the money supply. To forecast rates, analysts examine expected changes in the net demand for funds, which signals whether rates will rise or fall to restore equilibrium in the loanable funds market.

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Zamir Stanekzai
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230 views31 pages

Lecture-3 Determination of Interest Rates

The chapter discusses factors that affect interest rates using the loanable funds theory. It explains that interest rates are determined by the supply of and demand for loanable funds in the market. The demand for loanable funds comes from households, businesses, governments, and foreign entities, and is affected by economic growth, inflation expectations, and fiscal policies. The supply comes from savers like households and is impacted by inflation. Monetary policy by the central bank also influences interest rates by expanding or contracting the money supply. To forecast rates, analysts examine expected changes in the net demand for funds, which signals whether rates will rise or fall to restore equilibrium in the loanable funds market.

Uploaded by

Zamir Stanekzai
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Determination of Interest Rates

Prepared by Naeemullah Amani


CHAPTER OBJECTIVES
The specific objectives of this chapter are to:

 apply the loanable funds theory to explain why interest rates change,

 identify the most relevant factors that affect interest rate movements, and

 explain how to forecast interest rates.


Definitions of Interest rate

 An interest rate reflects the rate of return that a creditor


receives when lending money, or the rate that a borrower
pays when borrowing money.
 is a percentage charged on the total amount you borrow or
save.
Remember!

 Interest rate movements have a direct influence on the market values of debt

securities, such as bonds, and mortgages etc…

 They have an indirect influence on equity security values because they can

affect the return by investors who invest in equity securities.


 Since many financial institutions invest in securities (such as
bonds), the market value of their investments is affected by interest
rate movements.
LOANABLE FUNDS THEORY

 The loanable funds theory, commonly used to explain interest rate movements, suggests
that the market interest rate is determined by factors controlling the supply of and demand
for loanable funds.
 The phrase “demand for loanable funds” is widely used in financial markets to refer to
the borrowing activities of households, businesses, and governments.
 This chapter describes the sectors that commonly affect the demand for loanable funds and
then describes the sectors that supply loanable funds to the markets.
 Finally, the demand and supply concepts are combined to explain interest rate movements.
1. Household Demand for Loanable Funds
 Households commonly demand loanable funds to finance housing expenditures.
 In addition, they finance the purchases of automobiles and household items,
which results in installment debt. As the level of household income rises, so does
installment debt. The level of installment debt as a percentage of disposable income
has been increasing over time, although it is generally lower in recessionary periods.
 the results would reveal an inverse relationship between the interest rate and the
quantity of loanable funds demanded.
 This simply means that, at any moment in time, households would demand a greater
quantity of loanable funds at lower rates of interest; in other words, they are
willing to borrow more money at lower rates of interest.
 Example: the tax rate change
2. Business Demand for Loanable Funds

 Businesses demand loanable funds to invest in long-term (fixed) and short-term


assets. The quantity of funds demanded by businesses depends on the number of
business projects to be implemented. Businesses evaluate a project by comparing
the present value of its cash flows to its initial investment, as follows:

 The required return to implement a given project will be lower if interest rates are
lower because the cost of borrowing funds to support the project will be lower.
3. 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 loanable funds.
 Municipal (state and local) governments issue municipal bonds to obtain funds; the
federal government Treasury securities. These securities create government debt.
Example

 The federal government’s demand-for-loanable-funds schedule is represented by Dg1 in


Exhibit 2.3.
 If new bills are passed that cause a net increase of $200 billion in the deficit, the federal
government’s demand for loanable funds will increase by that amount.
 In the graph, this new demand schedule is represented by Dg2.
4. Foreign Demand for Loanable Funds

 A foreign country’s demand for U.S. funds (i.e., preference to borrow U.S. dollars) is
influenced by, among other factors, the difference between its own interest rates and
U.S. rates.
 Other things being equal, 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.
 As a result, for a given set of foreign interest rates, the quantity of U.S. loanable funds
demanded by foreign governments or firms will be inversely related to U.S. interest rates.
5. 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, as shown in Exhibit 2.5.
6. Supply of Loanable Funds

 The term “supply of loanable funds” is commonly used to refer to funds provided to
financial markets by savers.
 The household sector is the largest supplier, but loanable funds are also supplied by some
government units that temporarily generate more tax revenues than they spend or by some
businesses whose cash inflows exceed outflows.
 Suppliers of loanable funds are willing to supply more funds if the interest rate (reward
for supplying funds) is higher.
Equilibrium Interest Rate
Graphical Presentation
FACTORS THAT AFFECT INTEREST RATES

1. Impact of Economic Growth on Interest Rates


 Changes in economic conditions cause a shift in the demand curve for
loanable funds, which affects the equilibrium interest rate.
EXAMPLE
 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 that are worth pursuing, and they
are willing to borrow more funds. Their willingness to borrow more funds at any
given interest rate reflects an outward shift (to the right) in the demand curve.
2. Impact of Inflation on Interest Rates
 EXAMPLE Assume the U.S. inflation rate is expected to increase. Households that supply
funds may reduce their savings at any interest rate level so that they can make more
purchases now before prices rise. This shift in behavior is reflected by an inward shift (to the
left) in the supply curve of loanable funds.
 In addition, households and businesses may be willing to borrow more funds at any interest rate
level so that they can purchase products now before prices increase.
 This is reflected by an outward shift (to the right) in the demand curve for loanable funds.
Interest rates & Inflation
Interest rates

Nominal
Interest rates
Real Interest rates
=not adjusted for
=adjusted for inflation
inflation
=Quoted or stated
interest rate
3. Impact of Monetary Policy on Interest Rates

 The Federal Reserve can affect the supply of loanable funds by


increasing or reducing the total amount of deposits held at
commercial banks or other depository institutions.
 When the Fed increases the money supply, it increases the supply of
loanable funds and this places downward pressure on interest rates.
 Remember!
 When the US Economic conditions weakened. The Fed increased the
money supply in the banking system as a means of ensuring that funds
were available for households or businesses that wanted to borrow funds.
4. Impact of the Budget Deficit on Interest
Rates
 When the federal government passes fiscal policies that result in more expenditures than
tax revenue, the budget deficit is increased.

 Expenditures > tax revenue


 In such case the federal government issues treasury securities such as
 T-bills,
 T-notes and
 T-bonds
 When demand for loanable funds increases, thus it will increase interest rates.
FORECASTING INTEREST RATES

 To forecast future interest rates, the net demand for funds (ND) should be forecast:

 If the forecasted level of ND is positive or negative, then a disequilibrium will exist


temporarily.
 If ND is positive, the disequilibrium will be corrected by an upward adjustment in interest
rates;
 if ND is negative, the disequilibrium will be corrected by a downward adjustment.
 The larger the forecasted magnitude of ND, the larger the adjustment ininterest rates.
Thanks for your undivided
Attention throughout the
chapter 

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