Chapter Two

Determination of Interest Rates

 Loanable funds theory: used to explain interest rates movements.
 Factors control demand and supply for loanable funds.
 “Demand for loanable funds”: refer to the borrowing activities households, businesses
and governments.

1. Household Demand for Loanable: to finance housing expenses+ finance household

items in installments.

 Aggregate level of household income rises over time so does installment debt.
 Level of installment debt generally lower in recessionary times.
 Inverse relationship between interest rates and the quantity of loanable funds
demanded= house demand would be greater at lower rates interest

2. Business Demand for Loanable Funds: to invest in long term (fixed) and short.
 The quantity demand depends on number of projects to be implemented
 LT Positive NPV accepted if higher than costs.
n CFt
NPV= - Inv + ∑ ----------
t=1 (1+k)t
 ST = to fund business operations
 Opportunity costs of investing in short-term assets is higher when interest rates are
higher.
 Businesses demand more money when interest rates are lower.

 Shifts in the demand for loanable Funds: in good economic times expected cash
flows on various proposed projects will increase

 More projects will expect higher rates of return than required rates: Hurdle rate
 3. Government Demand For Loanable Funds:
 If taxes are not enough, it demands laonable funds.
 Funds obtained by bond issuing by state and local, federal issue TBs.
 Fed. Expenditures and taxes are independent of interest rates (demand for funds
is interest-inelastic. Some time municipals postpone demand for fund s and that
makes interest sensitive. Gov. demand for funds can shift if new bonds are issued

4. Foreign Demand for Funds: in any market foreign demand is included

 Foreign demand is influenced by the difference between the interest rates in each
country (inverse relation)
 If interest rates in a foreign country rises the demand for US dollar will shift
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 Aggregate Demand for Loanable Funds: the sum of quantities of demanded funds
by various economic sectors at any given interest rate
 Aggregate demand is inversely related to interest rates at any point in time
 If the demand of any sector changes the aggregate demand changes

5. Supply of Loanable Funds: funds provided to financial markets by savers

 Household sector is the largest supplier of funds
 Government and business represent the net demanders of loanable funds
 If interest rates are higher, suppliers are more willing to supply funds
 Foreign, governments and businesses supply funds to their domestic markets by
purchasing domestic securities
 The large supply of funds to US is attributed to the high savings rates of foreign
households
 H.H will keep supplying even if interest rates are low, they postpone
consumption
6. Effects of the Fed:
 The supply of loanable funds is also affected by fed monetary policy. The policy is to
control economic conditions.
7. Aggregate Supply of Funds: aggregate supply of the quantity of loanable funds is
expected to be less sensitive to (inelastic) interest rate but aggregate demand for loanable
funds is interest sensitive (elastic)
 If interest income tax is decreased, then supply will be affected
 Financial institutions, although they channel funds they are not the ultimate suppliers
of funds (funds come from H.H, businesses and gov.

8. Equilibrium Interest Rates:

 Although there are many interest rates for different borrowers, interest rates across
borrowers tend to change in the same direction
 Equilibrium interest rate is the rate that equates AD with AS for funds

Agg. Demand = DA = Dh + Db + Dg + Dm +Df

Agg. Supply = SA = Sh + Sb + Sg + Sm + Sf

Equilibrium Interest rate = DA + SA

 If DA increases without increase in SA, there will be shortage in loanable funds =

Int. rates will rise because DA > SA
 If SA increases without increase in DA, there will be surplus in loanable funds =
Int. rates will fall because DA< SA
 DA and SA are changing

9. Economic Forces That Affect Interest Rates:

First we identify economic forces that cause the change in DA and SA and therefore
influence interest rates
 A. Impact of Economic Forces: economic condition cause shifts in Agg. Demand and
supply of loanable funds which affects equilibrium interest rates.
 In good economic conditions, businesses tend to expand their business
activities therefore demand more funds at any level of interest rates forcing
demand to shift upward
 In good economic conditions, households will increase their savings
therefore supply of funds will at any level of interest rates forcing supply to
shift upward
 Economic growth puts upward pressure on interest rates
 Economic slowdown puts downward pressure on interest rates
 Business expansion will cause increase in demand but no obvious change in
supply

B. Impact of Inflation on Interest Rates:

 Changes in inflationary expectation can affect interest rates by affecting the
amount of spending by H.H and businesses.
 Decisions to spend affect the amount of saved and amount borrowed.
 If inflation is expected to rise, H.H reduce their savings at any interest rate so
they can make more purchases now before prices rise.
 In this case supply will shift inward.
 H.H and businesses might be willing to borrow more funds at any interest rate
level so they can purchase prices increase.
 Demand will shift downward.
 Equilibrium interest rate is higher

C. Fisher Effect: