lecture 2 2011
TRANSCRIPT
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Lecture 2
Determination of Interest Rates
Angeliki Theophilopoulou
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Determination of Interest RatesOutline
y Loanable funds theory
y Economic forces that affect interest rates
y Forecasting interest rates
Reading:y Madura 2008,ch.2
Additional Reading:
y I
nflation Report from Bank of Englandy Mishkin & Eakins, ch. 4, 5th edition
y Yvon Fauvel & Alain Paquet & Christian Zimmermann, 1999. "ASurvey on Interest Rate Forecasting," Cahiers de recherche CREFE/ CREFE Working Papers 87, CREFE, Universit du Qubec Montral.
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Loanable Funds Theoryy Loanable funds theorysuggests that the market
interest rate is determined by the factors that
affect the supply of and demand for loanable funds
y Can be used to explain movements in the general levelofinterest rates of a particular country
y Can be used to explain why interest rates among debtsecurities of a given countryvary
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Aggregate Demand for Loanable
FundsyHousehold demand for loanable funds
yHouseholds demand loanable funds to
finance:y Housing expenditures
y Automobiles
y Household items
yThere is an inverse relationship between theinterest rate and the quantity of loanablefunds demanded
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Aggregate Demand for Loanable
Funds (contd)yBusiness demand for loanable funds
y Businesses demand loanable funds to invest in fixed assets
and short-term assetsy Businesses evaluate projects using net present value (NPV):
y Projects with a positive NPV are accepted
y There is an inverse relationship between interest rates and
business demand for loanable funds
!
!
n
t
t
t
k
CFINVNPV
1 )1(
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Aggregate Demand for Loanable
Funds (contd)y Government demand for loanable funds
y Governments demand funds when planned
expenditures are not covered by incoming revenuesy Municipalities issue municipal bonds (US)
y The government issues Treasury securities
y Gilts are bonds issued by the governments of the UnitedKingdom, South Africa, or Ireland.
y Government demand for loanable funds isinterest-inelastic
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UK Public Sector Net Borrowingy Measured in millions of pounds sterling
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Aggregate Demand for Loanable
Funds (contd)yForeign Demand for loanable funds
y Foreign demand for U.K. funds is influenced bythe interest rate differential betweencountries
y The quantity ofU.K. loanable funds
demanded by foreign governments or firms isinversely related to U.K. interest rates
y The foreign demand schedule will shift inresponse to economic conditions
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Aggregate Demand for Loanable
Funds (contd)yAggregate demand for loanable funds
y The sum of the quantities demanded by theseparate sectors at any given interest rate isthe aggregate demand for loanable funds
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Aggregate Demand for Loanable
Funds (contd)
Dh
Household Demand
Db
Business Demand
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Aggregate Demand for Loanable
Funds (contd)
Dg
Government Demand Foreign Demand
Df
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Aggregate Demand for Loanable
Funds (contd)
DA
Aggregate Demand
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Aggregate Supply for Loanable
Funds (contd)ySupply of loanable funds (contd)
y Foreign households, governments, and
corporations supply funds by purchasingdomestic corporate and Treasury securitiesy The supply is influenced bymonetarypolicy
implemented by the Central Bank (BoE)y The BoE controls the amount of reserves held by
depository institutionsy The supply curve can shift in response to
economic conditionsy Economic growth, taxation etc,.
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Aggregate Supply for Loanable
Funds (contd)
SA
Aggregate Supply
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Equilibrium of Loanable Funds-
interest rateyEquilibrium interest rate - algebraic
y The aggregate demand can be written as
y
The aggregate supply can be written as
fmgbhA DDDDDD !
fmgbhA SSSSSS !
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Equilibrium of Loanable Funds-
interest rate
SA
Equilibrium Interest Rate - Graphic
DA
i
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Economic Forces That Affect Interest Rates
yEconomic growthy Shifts the demand schedule outward (to the
right)y There is no obvious impact on the supply
scheduley Supply could increase if income increases as a result of
the expansiony The combined effect is an increase in the
equilibrium interest rate
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Loanable Funds Theory (contd)SA
Impact of Economic Expansion
DA
i
DA2
i2
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Loanable Funds Theory (contd)SA
Impact of Expected Increase in Inflation
DA
i
DA2
i2
SA2
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Chart 2: CPI inflation projection based on markets
interest rates expectations and 200 billion asset
purchases
From BoE Inflation Report, November 2010
Which factors will affect inflation in 2011 for the UK?
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Fed target rate and price of crude
oil
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Economic Forces That Affect Interest Rates
(contd)
yFisher effecty Nominal interest payments compensate savers
for:
y Reduced purchasing power
yA premium for forgoing present consumption
y The relationship between interest rates andexpected inflation is often referred to as theFisher effect
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Economic Forces That Affect Interest
Rates (contd)yFisher effect (contd)
y Fisher effect equation:
y The difference between the nominal interest rate andthe expected inflation rate is the real interest rate:
y Real interest rate more accurately reflects true cost ofborrowing
yWhen real rate is low, greater incentives to borrow andless to lend
R
iINFEi !)(
)(INFEiiR
!
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Economic Forces That Affect Interest
Rates (contd)
yFisher effect (contd)y If the actual inflation rate is higher than
anticipated then borrowers benefit :it+1Et(it+1)
y Forecasting inf lation is crucial
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Distinction Between Real
and Nominal Interest Rates
If i = 3% E(i fl ti )= 1% t
ir = 3% - 1% = %
If i = 3% E(i fl ti ) = 3.5% t
ir = 3% - 3.5% = - .5 %
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Distinction Between Real
and Nominal Interest Rates
29The nominal interest rate shown here is the rate on US government five-year bonds. The inflation rate representsannual growth in the consumer price index. Source : J.F Nadeau 2009.
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Economic Forces That Affect Interest Rates
(contd)
yMoney supplyy If the CB increases the money supply, the supply
of loanable funds increasesy If inflationary expectations are affected, the demand
for loanable funds may also increase
y If the CB reduces the money supply, the supplyof loanable funds decreases
y The equilibrium interest rate goes up.
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Money Supplyy The total amount of money in the economy at a
particular point of time.
y
Definition for the UKy M0,monetary base:Cash outside Bank of England +Banks' operational depositswith Bank of England.
y M4, broad money:Cash outside banks (ie. in
circulation with the public and non-bank firms) +private-sector retail bank and building societydeposits + Private-sector wholesale bank and buildingsocietydeposits and Certificate of Deposit.
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B f E gl B R t
Source: Bank of England 2009
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Economic Forces That Affect Interest Rates
(contd)
yMoney supply (contd)y September 11 2001
y Firms cut back on expansion plansy Households cut back on borrowing plans
y The demand of loanable funds declined
y Theweak economy in 20012002y Reduced demand for loanable fundsy The CB increased the money supply growth
y Interest rates reached very low levels
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M4 for UK
-5
5
10
15
0
25
30
Oct-82
Oct-83
Oct-84
Oct-85
Oct-86
Oct-87
Oct-88
Oct-89
Oct-90
Oct-91
Oct-92
Oct-93
Oct-94
Oct-95
Oct-96
Oct-97
Oct-98
Oct-99
Oct-00
Oct-01
Oct-02
Oct-03
Oct-04
Oct-05
Oct-06
Oct-07
Oct-08
Series1
3 th growthrate(annualised)of M4
(monetary financial institutions'sterling M4 liabilitiesto rivatesector)(in
ercent)seasonallyadjusted, BoE
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UK 12 month growth rates of notes and coins
(Seasonally adjusted)
Source: Bloomberg 2009
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Economic Forces That Affect Interest Rates
(contd)yBudget deficit
yA high deficit means a high demand for loanablefunds by the governmenty Shifts the demand schedule outward (to the right)y Interest rates increase
y The government may be willing to pay whatever isnecessary to borrow funds, but the private sector
may noty Crowding-out effecty The supply schedule may shift outward if the government
creates more jobs by spending more funds than it collectsfrom the public (but in a smaller effect)
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Economic Forces That Affect Interest Rates
(contd)
yForeign flows of fundsy Shifts in the flows of funds between countries cause
adjustments in the supply of funds available in eachcountry
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Economic Forces That Affect Interest Rates
(contd)y Explaining the variation in interest rates over time
y Early 1980s: recession led to a decline in interest ratesy Late 1980s: interest rates increased in response to a strong
economyy Early 1990s: interest rates declined as a result of a weak
economyy 1994: interest rates increased as economic growth increased
y Drifted lower for next several years despite strong economic growth,partly due to the U.S. budget surplus
y 2001: interest rates decreased in response to pessimisticsentiments for the global economy.
y 2008: interest rates fall in historical lows trying to boost thelow economic activity and to combat the credit crunch andrecession.
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C
BsM
onetary Policy (target) rates
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Forecasting Interest Ratesy It is difficult to predict the precise change in
the interest rate due to a particular event
y Being able to assess the direction of supply ordemand schedule shifts can help inunderstanding why rates changed
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Forecasting Interest Rates (contd)y To forecast future interest rates, the net demand
for funds (ND) should be forecast:
? A
? Afmgbh
fmgbh
AA
SSSSS
SN
!
!
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Forecasting Interest Rates (contd)yApositive disequilibrium in NDwill be
corrected by an increase in interest rates
yAnegative disequilibrium in NDwill becorrected by a decrease in interest rates
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