Determination of Interest Rates

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