Chapter 4: The Behaviour of

Interest Rates

Prepared by: Mohammad Radzie OsmanMuhammad Syazmi Adli Zainal AbidinNickhlos Ak JalangCynthia Bunya

Concepts of interest rate and rate of return

Interest Rate Interest is a return on capital. It also refers to the price of money.

For the borrower, interest is a payment for obtaining credit (loan) or the cost of borrowing.

For the lender, it is the amount of funds, valued in terms of money that they receive when they extend credit. It is a reward for delaying their current consumption.

Rate of Return (ROR) Rates of returns are basically returns on investments or rewards of taking risks.

For any security, the ROR is defined as the payments to the owner plus the change in its value, expressed as a fraction of its purchase price.

the return on a bond will not necessarily equal the interest rate (YTM) on that bond.

Rates of returns also can be defined as rewards for giving up current use of funds.

Returns vary according to the investment vehicles being undertaken. For example, the rates of returns on stocks, bonds, savings, etc.

Concept of nominal and real interest rates

Nominal Interest Rates Nominal interest rate is the rate of interest that is accrued at some time in the future.

It is the rate of exchange between RM now and RM in the future.

For example, if the nominal interest rate is 10% per annum, then a sum of RM10 borrowed this year, is payable for a sum of RM11 next year.

Nominal interest rate makes no allowance for inflation, that is, it ignores the effects of inflation.

Real Interest Rate Real interest rate is the rate of interest at some time in future after discounting the

rate of inflation. The interest rate is adjusted for expected changes in the price level so that it more accurately reflects the true cost of borrowing.

The real interest rate is more accurately defined by the Fisher equation, named for Irving Fisher. The equation states that the nominal interest rate (i) equals the real interest rate is plus the expected rate of inflation. For example, if the nominal interest rate is 10% per annum and the inflation rate is 3%, the real interest rate is really 7%.

Rewriting the equation, we get:

i.Real = Nominal – Expected Inflation.

ii.Nominal = Real + Expected Inflation.

Determination of the market interest rate

Determinants of Asset Demand. Wealth: the total resources owned by the individual, including all assets Expected Return: the return expected over the next period on one asset

relative to alternative assets Risk: the degree of uncertainty associated with the return on one asset relative

to alternative assets Liquidity: the ease and speed with which an asset can be turned into cash

relative to alternative assets

Theory of Asset Demand

Holding all other factors constant:1. The quantity demanded of an asset is positively related to wealth

2. The quantity demanded of an asset is positively related to its expected return relative to alternative assets

3. The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets

4. The quantity demanded of an asset is positively related to its liquidity relative to alternative assets

Loanable Fund Theory- Fisherian Real Interest Rate

In this theory ,Real interest rate is determined by the equilibrium of demand for loanable funds(Investment) and supply of loanable funds(savings).

The theory emphasis on the flow of credit (loanable funds) rather than money stock.

Loanable funds = Savings = Surplus fund ready to lent out.

CLASSICAL THEORY

Supplier of loanable funds are(Slf)

Demand for loanable funds are(Dlf)

House hold = Saving

Firm = Undistributed profits

Federal + state government = budget surplus

Increase in money stock

Decrease in demand for money

House hold= Consumption

Firm= Investment

Federal + state government = budget Deficit

Decreased in money stock

Increase in demand for money.

Aggregate saving Schedule = Supply schedule for loanable fund

Real interest rate = Price of loanable Funds

Aggregate Investment Schedule = Demand schedule for loanable funds

Real In rate= Price of loanable Funds(Credit)

Conclusion :

• In diagram 3, IR is determined by the interaction of the agg investment and Aggregate S A.

• If IR r1 increase above the equilibrium level 5,There will be an excess supply of loanable and saving exceed desired investment.SA will offer lower interest rate to include deficit units to borrow their excess loanable fund.• The supply of loanable funds comes from people who have extra income they want to save and lend out.

• The demand for loanable funds comes from households and firms that wish to borrow to make investments.

The Interest Rate EffectA rising price level pushes up interest rates, which in turn lower the consumption of certain goods and services and also lower investment in new plant and equipment:

A rising price level pushes up interest rates and lowers both consumption and investment

A declining price level pushes down interest rates and encourages both consumption and investment

Table 1 Response of the Quantity of an Asset Demanded to Changes in Wealth, Expected Returns, Risk, and Liquidity

Supply and Demand in the Bond Market

• At lower prices (higher interest rates), ceteris paribus, the quantity demanded of bonds is higher: an inverse relationship

• At lower prices (higher interest rates), ceteris paribus, the quantity supplied of bonds is lower: a positive relationship

Market Equilibrium• Occurs when the amount that people are willing to buy (demand) equals the

amount that people are willing to sell (supply) at a given price

• Bd = Bs defines the equilibrium (or market clearing) price and interest rate. • When Bd > Bs , there is excess demand, price will rise and interest rate will fall• When Bd < Bs , there is excess supply, price will fall and interest rate will rise

Figure 1 Supply and Demand for Bonds

Changes in Equilibrium Interest Rates

Shifts in the demand for bonds:• Wealth: in an expansion with growing wealth, the demand curve for bonds shifts to

the right • Expected Returns: higher expected interest rates in the future lower the expected

return for long-term bonds, shifting the demand curve to the left• Expected Inflation: an increase in the expected rate of inflations lowers the

expected return for bonds, causing the demand curve to shift to the left• Risk: an increase in the riskiness of bonds causes the demand curve to shift to the

left• Liquidity: increased liquidity of bonds results in the demand curve shifting right

Figure 2 Shift in the Demand Curve for Bonds

Table 2: Factors That Shift the Demand Curve for Bonds

Table 3: Factors That Shift the Supply of Bonds

Figure 3 Shift in the Supply Curve for Bonds

Figure 4 Response to a Change in Expected Inflation

Figure 5 Response to a Business Cycle Expansion

KEYNESIAN MODEL Introduced by John Maynard Keynes Refers to the demand for money, considered as liquidity Keynes defines the rate of interest as the reward for parting with liquidity for a

specified period of time. According to him, the rate of interest is determined by the demand for and

supply of MONEY Has abandoned the classical view

Money velocity was constant and emphasized the important of interest rate.

Transactions Motive The transactions motive relates to the demand for money or the need of CASH for

the current transactions of individual and BUSINESS exchanges. Individuals hold cash in order to bridge the gap between the receipt of income

and its expenditure. (income motive) The businessmen also need to hold ready cash in order to meet their current

needs like payments for raw materials, transport, wages etc. (business motive)

Precautionary motive: Precautionary motive for holding money refers to the desire to hold cash balances for

unforeseen contingencies. Individuals hold some cash to provide for illness, accidents, unemployment and other unforeseen contingencies. Similarly, businessmen keep cash in reserve to tide over unfavorable conditions or to gain from unexpected deals.

Keynes holds that the transaction and precautionary motives are relatively interest inelastic, but are highly income elastic. The amount of money held under these two motives (M1) is a function (L1) of the level of income (Y) and is expressed as M1 = L1 (Y)

Interest rate

Money Demand

L1

FIGURE 6

Speculative Motive Refers to people holding money as a store of wealth Divide the assets that can be used to store wealth into 2 categories:

money bonds

Interest rate has important role n influencing how much money to hold as a store of wealth

According to Keynes, the higher the rate of interest, the lower the speculative demand for MONEY, and lower the rate of interest, the higher the speculative demand for 

Determination of the Rate of Interest

FIGURE 7

Supply and Demand in the Market for Money: The Liquidity Preference

FrameworkKeynesian model that determines the equilibrium interest rate

in terms of the supply of and demand for money. There are two main categories of assets that people use to store

their wealth: money and bos s d d

s d s d

s d

s d

nds.

Total wealth in the economy = B M = B + M

Rearranging: B - B = M - M

If the market for money is in equilibrium (M = M ),

then the bond market is also in equilibrium (B = B ).

Figure 8 Equilibrium in the Market for Money

Demand for Money in the Liquidity Preference Framework

• As the interest rate increases:– The opportunity cost of holding money increases…– The relative expected return of money decreases…

• therefore the quantity demanded of money decreases.

Changes in Equilibrium Interest Rates in theLiquidity Preference Framework

Shifts in the demand for money:

• Income Effect: a higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right

• Price-Level Effect: a rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right

Shifts in the demand for money:

• Income Effect: a higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right

• Price-Level Effect: a rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right

Table 4 Factors That Shift the Demand for and Supply of Money

Figure 9 Response to a Change in Income or the Price Level

Figure 10 Response to a Change in the Money Supply

THANK YOU FOR LISTENING

Q & A