Determination of Interest Rates
Are Interest Rate Movements Relevant?
n Changes in interest rates impact the real economy
l Investment spending
l Interest sensitive consumer spending such as housing
n Interest rate changes affect the values of all securities
l Security prices vary inversely with interest rates
n Interest rates changes impact the value of financial institutions
l Affects cash flows
l Interest rate risk is a major risk impacting financial institutions
Loanable Funds Theory of Interest Rate Determination
n Interest rates determined by demand and supply for loanable funds
n Demand = borrowers, issuers of securities
n Supply = lenders, financial investors, buyers of securities
n Assume economy divided into sectors
n Slope of demand/supply curves related to elasticity or sensitivity of interest rates
Demand for Loanable Funds
Loanable Funds Theory
l Households demand loanable funds to finance housing, automobiles, household items
l These purchases result in installment debt. Installment debt increases with the level of income
Loanable Funds Theory
l Businesses demand funds to invest in assets
l Quantity of funds demanded depends on how many projects to be implemented
u Businesses choose projects with NPV>0
l If interest rates decrease, more projects will have a positive NPV
u Businesses will demand more loanable funds
Loanable Funds Theory
l When planned expenditures exceed revenues from taxes, the government demands loanable funds
u Municipal bonds and Treasury securities
l Federal government expenditure and tax policies are independent of interest rates
u Government demand for funds is interest-inelastic
Loanable Funds Theory
l A foreign country’s demand for U.S. funds is influenced by the differential between its interest rates and U.S. rates
Loanable Funds Theory
l The aggregate demand for loanable funds is the sum of the quantities demanded by the separate sectors
Supply of Loanable Funds
n Sum of sector supply (quantity) at varying levels of interest rates
Loanable Funds Theory
n Equilibrium Interest Rate
l Aggregate Demand
DA = Dh + Db + Dg + Df
l Aggregate Supply
SA = Sh + Sb + Sg + Sf
In equilibrium, DA = SA
Graphic Presentation
Economic Forces That Affect Interest Rates
n Economic Growth
l Higher disposable income
l New technological applications with +NPV’s
l Expected impact is an outward shift in the demand schedule without obvious shift in supply
l Result is an increase in the equilibrium interest rate
Economic Forces That Affect Interest Rates
n Inflation
l The Fisher Effect
u Nominal Interest Rates = Sum of Real Rate plus Expected Rate of Inflation
Economic Forces That Affect Interest Rates
n Inflation
l If inflation is expected to increase
u Households may reduce their savings to make purchases before prices rise
u Supply shifts to the left, raising the equilibrium rate
u Also, households and businesses may borrow more to purchase goods before prices increase
u Demand shifts outward, raising the equilibrium rate
Economic Forces That Affect Interest Rates
n Monetary Policy
l When the Fed increases the money supply, it increases supply of loanable funds
l Places downward pressure on interest rates
Economic Forces That Affect Interest Rates
n Federal Government Budget Deficit
l Increase in deficit increases the quantity of loanable funds demanded
l Demand schedule shifts outward, raising rates
l Government is willing to pay whatever is necessary to borrow funds, “crowding out” the private sector
Economic Forces That Affect Interest Rates
n Foreign Flows
l In recent years there has been massive flows between countries
l Driven by large institutional investors seeking high returns
l They invest where interest rates are high and currencies are not expected to weaken
l These flows affect the supply of funds available in each country
l Investors seek the highest real after-tax, exchange rate adjusted rate of return around the world
Forecasting Interest Rates
n Forecast economic sector activity and impact upon demand/supply of loanable funds
n Forecast incremental effects on interest rates
n Forecasting interest rates has been difficult