Chapter ObjectivesExplain Loanable Funds Theory of Interest Rate DeterminationIdentify Major Factors Affecting the Level of Interest RatesExplain How to Forecast Interest Rates

Relevance of Interest Rate MovementsChanges in interest rates impact the real economyInvestment spendingInterest sensitive consumer spending such as housingInterest rate changes affect the values of all securitiesSecurity prices vary inversely with interest ratesVarying interest rates impact retirement funds and retirement incomeInterest rates changes impact the value of financial institutionsManagers of financial institutions closely monitor ratesInterest rate risk is a major risk impacting financial institutions

Loanable Funds Theory of Interest Rate DeterminationTheory of how the general level of interest rates are determinedExplains how economic and other factors influence interest rate changesInterest rates determined by demand and supply for loanable funds

Loanable Funds Theory, cont.Demand = borrowers, issuers of securities, deficit spending unitSupply = lenders, financial investors, buyers of securities, surplus spending unitAssume economy divided into sectorsSlope of demand/supply curves related to elasticity or sensitivity of interest rates

Sectors of the EconomyHousehold Sector--Usually a net supplier of loanable fundsBusiness SectorUsually a net demander in growth periodsGovernment SectorsStatesBorrow for capital projectsFederalBorrow for capital projects and deficit spending Foreign SectorsNet supplier since early 1980s

Demand for Loanable FundsSum of sector demand (quantity) at varying levels of interest ratesSector cash receipts in period less than outlays = borrowerQuantity demanded inversely related to interest ratesVariables other than interest rate changes cause shift in demand curve

Demand for Loanable FundsInterest RateQuantity of Loanable Funds

Loanable Funds Theory

Households demand loanable funds to finance housing, automobiles, household itemsThese purchases result in installment debt. Installment debt increases with the level of incomeThere is an inverse relationship between the interest rate and the quantity of loanable funds demandedHousehold Demand for Loanable Funds

Loanable Funds Theory

Businesses demand loanable funds to invest in assetsQuantity of funds demanded depends on how many projects to be implementedBusinesses choose projects by calculating the projects Net Present ValueSelect all projects with +NPVsBusiness Demand for Loanable Funds

Loanable Funds Theory

Net Present Value is calculated as follows:Business Demand for Loanable Funds

Loanable Funds Theory

Projects with a positive NPV are accepted because the present value of their benefits outweighs their costsIf interest rates decrease, more projects will have a positive NPVBusinesses will need a greater amount of financingBusinesses will demand more loanable fundsBusiness Demand for Loanable Funds

Loanable Funds Theory

There is an inverse relationship between interest rates and the quantity of loanable funds demandedThe curve can shift in response to events that affect business borrowing preferencesExample: Economic conditions become more favorableExpected cash flows will increase > more positive NPV projects > increased demand for loanable fundsBusiness Demand for Loanable Funds

Loanable Funds Theory

When planned expenditures exceed revenues from taxes, the government demands loanable fundsMunicipal (state and local) governments issue municipal bondsFederal government and its agencies issue Treasury securities and federal agency securities.Government Demand for Loanable Funds

Loanable Funds Theory

Federal government expenditure and tax policies are independent of interest ratesGovernment demand for funds is interest-inelasticDInterestRateQuantity of Loanable FundsGovernment Demand for Loanable Funds

Loanable Funds Theory

A foreign countrys demand for U.S. funds is influenced by the differential between its interest rates and U.S. ratesThe quantity of U.S. loanable funds demanded by foreign investors will be inversely related to U.S. interest rates Foreign Demand for Loanable Funds

Loanable Funds Theory

The aggregate demand for loanable funds is the sum of the quantities demanded by the separate sectorsThe aggregate demand for loanable funds is inversely related to interest ratesAggregate Demand for Loanable Funds

Sector Supply of Loanable FundsHouseholds are major suppliers of loanable fundsBusinesses and governments may invest (loan) funds temporarilyForeign sector a net supplier of funds in last twenty yearsFederal Reserves monetary policy impacts supply of loanable funds

Supply of Loanable FundsSum of sector supply (quantity) at varying levels of interest ratesSector cash receipts in period greater than outlayslenderQuantity supplied directly related to interest ratesVariables other than interest rate changes causes a shift in the supply curve

InterestRateQuantity of Loanable Funds

Loanable Funds TheoryEquilibrium Interest RateAggregate DemandDA = Dh + Db + Dg + Dm + Df

Aggregate SupplySA = Sh + Sb + Sg + Sm + Sf

In equilibrium, DA = SA

Graphic PresentationInterest RatesQuantity of Loanable Funds

Loanable Funds TheoryGraphic PresentationWhen a disequilibrium situation exists, market forces should cause an adjustment in interest rates until equilibrium is achievedExample: interest rate above equilibriumSurplus of loanable fundsRate fallsQuantity supplied reduced, quantity demanded increases until equilibrium

General Equilibrium Interest RateMeans of explaining how economic factors affect interest rate levelsInterest rate level where quantity of aggregate loanable funds demanded = supplySurplus and shortage conditionsSurplus- Quantity demanded < quantity supplied followed by market interest rate decreasesShortageGovernment interest rate ceilings below market interest rates

Interest Rate Changes+ Directly related to level of economic activity or growth rate of economic activity+ Directly related to expected inflation Inversely related to rates of money supply changes

Economic Forces That Affect Interest RatesEconomic GrowthExpected impact is an outward shift in the demand schedule without obvious shift in supplyNew technological applications with +NPVsResult is an increase in the equilibrium interest rate

Economic Forces That Affect Interest Rates: The Fisher EffectLenders want to be compensated for expected loss of purchasing power (inflation) when they lendNominal Interest Rates = Sum of real rate plus expected rate of inflation,Expected Real Rate (ex ante) = expected increase in purchasing power in periodRealized Real Rate (ex post) = nominal rates less actual rate of inflation in period

Economic Forces That Affect Interest RatesInflationThe Fisher EffectNominal Interest Rates = Sum of Real Rate plus Expected Rate of Inflation

inirE(I)+=

Figure 2.12 here

Economic Forces That Affect Interest RatesInflationIf inflation is expected to increaseHouseholds may reduce their savings to make purchases before prices riseSupply shifts to the left, raising the equilibrium rateAlso, households and businesses may borrow more to purchase goods before prices increaseDemand shifts outward, raising the equilibrium rate

Economic Forces That Affect Interest RatesMoney SupplyWhen the Fed increases the money supply, it increases supply of loanable fundsPlaces downward pressure on interest rates

Economic Forces That Affect Interest RatesFederal Government Budget DeficitIncrease in deficit increases the quantity of loanable funds demandedDemand schedule shifts outward, raising ratesGovernment is willing to pay whatever is necessary to borrow funds, crowding out the private sector

Economic Forces That Affect Interest RatesForeign FlowsIn recent years there has been massive flows between countriesDriven by large institutional investors seeking high returnsThey invest where interest rates are high and currencies are not expected to weakenThese flows affect the supply of funds available in each countryInvestors seek the highest real after-tax, exchange rate adjusted rate of return around the world

Forecasting Interest RatesAttempts to forecast demand/supply shiftsForecast economic sector activity and impact upon demand/supply of loanable fundsForecast incremental effects on interest ratesForecasting interest rates has been difficult

Summary: Key Factors Impacting Interest Rates Over TimeEconomic GrowthIncreased growth; increased demand for funds; interest rates increaseExpected inflation--security prices fall; interest rates increaseGovernment budgetsDeficitincrease borrowing; security prices fall, interest rates increaseSurplusdecreased borrowing; security prices increase; interest rates decreaseIncreased foreign supply of loanable fundssecurity prices increase; interest rates decrease