DETERMINATION OF INTEREST RATES

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 1. The Loanable Funds Theory suggests that the
market interest rate is determined by the factors
that control supply of and demand for loanable
funds.
2. Can be used to explain:
a. Movements in the general level of interest
rates in a particular country
b. Why interest rates among debt securities of a
given country vary.

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 1. Household demand for loanable funds
a. Households demand loanable funds to finance housing
expenditures as well as the purchase of automobiles
and household items.
b. Inverse relationship between the interest rate and the
quantity of loanable funds demanded.

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 2. Business demand for loanable funds
a. Depends on number of business projects to be
implemented. More demand at lower interest rates.
(Exhibit 2.2)
n
CFt
NPV INV
t 1 (1 k ) t

NPV net present value of project

INV initial investment
CFt cash flow in period t
k required rate of return on project
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 3. Government demand for loanable funds
a. Governments demand loanable funds when planned
expenditures are not covered by incoming revenues.
b. Government demand is said to be interest inelastic:
insensitive to interest rates. Expenditures and tax
policies are independent of the level of interest rates.
(Exhibit 2.3)

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 In
terest Rates reflect the cost of credit (borrowing).
Th
e movement of interest rates is determined by:
Supply of Credit and the Demand for same.
Increases in supply, ceteris paribus, leads to lower interest rates.
Increases in Demand, ceteris paribus, leads to higher interest rates.
In
terest rates are positively affected by inflationary expectations (in a free
and efficient market):

-> Inflation Rates

In
terest rates are also affected by risk perceptions

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 1. Households are largest supplier, but some supplied by
government units.
a. More supply at higher interest rates.
b. Supply by buying securities.
2. Effects of the Fed - By affecting the supply of loanable
funds, the Feds monetary policy affects interest rates.
3. Aggregate supply of funds Is the combination of all
sector supply schedules along with the supply of funds
provided by the Feds monetary policy. (Exhibit 2.6)

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 Impact of Monetary Policy on Interest Rates
When the Fed reduces (increases) the money supply, it
reduces (increases) the supply of loanable funds, putting
upward (downward) pressure on interest rates.
Impact of the Budget Deficit on Interest Rates
Crowding-out Effect: Given a certain amount of loanable
funds supplied to the market, excessive government
demand for funds tends to crowd out the private
demand for funds. (Exhibit 2.11)
Impact of Foreign Flows of Funds on Interest Rates
Interest rate for a certain currency is determined by the
demand for funds in that currency and the supply of funds
available in that currency. (Exhibit 2.12)
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 1. Net Demand (ND) should be forecast:
ND = DA SA
ND = (Dh + Db + D,m + Dr) (Sh + Sb + Sm + Sf)

2. Future Demand for Loanable Funds depends on future

a. Foreign demand for U.S. funds
b. Household demand for funds
c. Business demand for funds
d. Government demand for funds

3. Future Supply of Loanable Funds depends on:

a. Future supply by households and others
b. Future foreign supply of loanable funds in the U.S.

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 1. Impact of economic growth on interest rates:
a. Puts upward pressure on interest rates by shifting demand
for loanable funds outward. (Exhibits 2.8 & 2.9)

2. Impact of inflation on interest rates:

a. Puts upward pressure on interest rates by shifting supply of
funds inward and demand for funds outward. (Exhibit 2.10)
b. Fisher effect: i = E(INF) + iR
where i = nominal or quoted rate of interest
E(INF) = expected inflation rate
iR = real interest rate

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 H
ouseholds are net suppliers of funds.

G
overnments may also supply funds*
The Fiscal Year 2009 Stimulus generated approximately $800 Billion in credit
(debt).

F
ederal Reserve Monetary Policy
Reduce reserve requirement
Buy Securities from member banks

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ouseholds
Consumption above current income levels financed with borrowing.

usiness
Finance asset expansion.

overnment
Cover expenditures in excess of tax receipts.
Demand for funds Inelastic with respect to rates.

oreign
Same reasons as "A" and "B" as well as "C"
Additional sources of [FOREX] risk

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 E
quilibrium = point at which markets clear (no excess supply or demand).
Question: Is an equilibrium point observable?
Question: Is equilibrium an important concept?

C
hanges in the Equilibrium Interest Rate
Change in response to changes in supply of funds
Change in response to changes in demand for funds

T
he Fisher Effect
Preserving Purchasing Power
Components of the Nominal Rate of Interest

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 G
overnment Budget Deficits and Interest Rates
Does government competition for loanable funds increase the cost?
What arguments support deficit spending?

I
mpact of Foreign Interest Rates
Mobility of international capital domestic rates
Differences in international investment opportunity sets

I
mpact of Exogenous Events on Interest Rates
Unexpected international events: wars and rumors of war
Sovereign debt crises

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actors in forecasts: (see Ex 2.14)
Foreign demand (vs. foreign supply)
Household demand (vs. household supply)
Business demand
Depends on investment opportunity set
Government demand
Fiscal Policy drives borrowing
Fiscal Policy a function of economic policy goals

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 W
hom demands and supplies funds in the Loanable Funds Theory?
H
ow does the supply of and demand for money [credit] impact
interest rates?
W
hat causes changes in interest rates?
W
hat is the Fisher Effect and why is it important?
W
hat exogenous forces affect interest rates?
Q
&A: 2,6,12 Interpreting: a, b, c

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