Chapter 2: Determination of

Interest Rates
Objectives

■ apply the loanable funds theory to explain

why interest rates change
■ identify the most relevant factors that
affect interest rate movements
■ explain how to forecast interest rates
Loanable Funds Theory
1. The Loanable Funds Theory suggests that
the market interest rate is determined by the
factors that control supply of and demand for
loanable funds.
2. Can be used to explain:
 Movements in the general level of interest
rates in a particular country
 Why interest rates among debt securities of a
given country vary.
Loanable Funds Theory

⚫Demand = borrowers, issuers of securities,

deficit spending unit
⚫Supply = lenders, financial investors,
buyers of securities, surplus spending unit
⚫Assume economy divided into sectors
⚫Slope of demand/supply curves related to
elasticity or sensitivity of interest rates
Loanable Funds Theory

⚫Household Sector--Usually a net supplier

of loanable funds
⚫Business Sector—Usually a net demander
in growth periods
⚫Government Sectors: Borrow for capital
projects and deficit spending
⚫Foreign Sectors—Net supplier or
demander
Demand for Loanable Funds

1. Household demand for loanable funds

a. Households demand loanable funds to
finance housing expenditures as well
as the purchase of automobiles and
household items.
b. Inverse relationship between the
interest rate and the quantity of
loanable funds demanded.
Relationship between Interest Rates and
Household Demand (Dh) for Loanable Funds at a
Given Point in Time
Demand for Loanable Funds
2. Business demand for loanable funds
a. Depends on number of business projects to be
implemented. More demand at lower interest rates.
n
CFt
NPV = − INV + 
t =1 (1 + k ) t

NPV = net present value of project

INV = initial investment
CFt = cash flow in period t
k = required rate of return on project
Demand for Loanable Funds
⚫Projects with a positive NPV are accepted
because the present value of their benefits
outweighs their costs
⚫If interest rates decrease, more projects will
have a positive NPV
Businesses will need a greater amount of
financing
Businesses will demand more loanable
funds
Relationship between Interest Rates and Business
Demand (Db) for Loanable Funds at a Given Point
in Time
Demand for Loanable Funds

3. Government demand for loanable funds

a. Governments demand loanable funds
when planned expenditures are not
covered by incoming revenues.
b. Government demand is said to be
interest inelastic: insensitive to
interest rates. Expenditures and tax
policies are independent of the level of
interest rates.
Impact of Increased Government Deficit on the
Government Demand for Loanable Funds
Demand for Loanable Funds

4. Foreign demand for loanable funds

a.A foreign country’s demand for domestic
funds depends on the interest rate
differential between the two.
b.The quantity of domestic loanable funds
demanded by foreign investors will be
inversely related to domestic interest
rates.
Impact of Increased Foreign Interest Rates on the
Foreign Demand for U.S. Loanable Funds
 Demand for Loanable Funds
Aggregate demand for loanable funds
 The sum of the quantities demanded by the
separate sectors at any given interest rate
DA = Dh + Db + Dg + Dm + Df
Dh = household demand for loanable funds
Db = business demand for loanable funds
Dg = federal government demand for loanable
funds
Dm = municipal government demand for
loanable funds
Df = foreign demand for loanable funds
Determination of the Aggregate
Demand Curve for Loanable Funds
Supply of Loanable Funds
1. Households are largest supplier, but
businesses and governments may invest (loan)
funds temporarily.
 More supply at higher interest rates.
 Supply by buying securities.
2. Effects of the central bank (US: Fed,
Vietnam: SBV) - By affecting the supply of
loanable funds, the central bank’s monetary
policy affects interest rates.
3. Variables other than interest rate changes
causes a shift in the supply curve
 Supply of Loanable Funds
Aggregate supply of funds –Is the combination of all
sector supply schedules along with the supply of funds
provided by the central bank’s monetary policy.
SA = Sh + Sb + Sg + Sm + Sf
Sh = household supply for loanable funds
Sb = business supply for loanable funds
Sg = federal government supply for loanable
funds
Sm = municipal government supply for loanable
funds
Sf = foreign supply for loanable funds
Aggregate Supply Curve for
Loanable Funds
Equilibrium Interest Rate
Equilibrium Interest Rate
⚫ Interest rate level where quantity of aggregate
loanable funds demanded = supply
⚫ When a disequilibrium situation exists, market
forces should cause an adjustment in interest rates
until equilibrium is achieved
⚫ Surplus and shortage conditions
Surplus- Quantity demanded < quantity
supplied followed by market interest rate
decreases
Shortage- followed by market interest rate
increases
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
Rates: Economic Growth
1. Impact of Economic Growth
Expected impact is an outward shift in
the demand schedule without obvious
shift in supply
New technological applications with
positive NPVs
Result is an increase in the equilibrium
interest rate
Impact of Increased Expansion by Firms
Impact of an Economic Slowdown
 Economic Forces That Affect Interest
Rates: Inflation
2. Impact of inflation on interest rates
a. Lenders want to be compensated for
expected loss of purchasing power
(inflation) when they lend
b.Fisher effect: i = E(INF) + iR
where i = nominal or quoted rate of
interest
E(INF) = expected inflation rate
iR = real interest rate
Economic Forces That Affect Interest
Rates: Inflation
⚫ If inflation is expected to increase: Puts upward
pressure on interest rates by shifting supply of
funds inward and demand for funds outward.
Households may reduce their savings to make
purchases before prices rise
Supply shifts to the left, raising the equilibrium
rate
Also, households and businesses may borrow
more to purchase goods before prices increase
Demand shifts outward, raising the equilibrium
rate
Impact of an increase in expected
inflation
Economic Forces That Affect Interest
Rates: Money Supply
3. Impact of money supply
⚫Money Supply
When the central bank increases the
money supply, it increases supply of
loanable funds
Places downward pressure on interest
rates
Economic Forces That Affect Interest
Rates: Budget Deficit
4. Impact of budget deficit
Increase in deficit increases the quantity
of loanable funds demanded
Demand schedule shifts outward,
raising rates
Government is willing to pay whatever
is necessary to borrow funds, “crowding
out” the private sector
Economic Forces That Affect Interest
Rates: Foreign Flows
4. Impact of foreign flows
In recent years there has been massive flows
between countries
Driven by large institutional investors seeking
high returns
They invest where interest rates are high and
currencies are not expected to weaken
These flows affect the supply of funds available
in each country
Investors seek the highest real after-tax,
exchange rate adjusted rate of return around the
world
Forecasting Interest Rates

⚫Attempts to forecast demand/supply shifts

⚫Forecast economic sector activity and
impact upon demand/supply of loanable
funds
⚫Forecast incremental effects on interest
rates
⚫Forecasting interest rates has been
difficult
Forecasting Interest Rates
1. Future Demand for Loanable Funds depends on
future
a. Foreign demand for domestic funds
b. Household demand for funds
c. Business demand for funds
d. Government demand for funds
2. Future Supply of Loanable Funds depends on:
a. Future supply by households and others
b. Future foreign supply of loanable funds in the
country.
Summary

▪ The loanable funds framework shows how

the equilibrium interest rate depends on
the aggregate supply of available funds
and the aggregate demand for funds. As
conditions cause the aggregate supply or
demand schedules to change, interest
rates gravitate toward a new equilibrium
Summary

▪ Given that the equilibrium interest rate is

determined by supply and demand
conditions, changes in the interest rate
can be forecasted by forecasting changes
in the supply of and the demand for
loanable funds. Thus, the factors that
influence the supply of funds and the
demand for funds must be forecast in
order to forecast interest rates.
Summary
⚫ The relevant factors that affect interest rate
movements include changes in economic growth,
inflation, the budget deficit, foreign interest rates,
and the money supply. These factors can have a
strong impact on the aggregate supply of funds
and/or the aggregate demand for funds and can
thereby affect the equilibrium interest rate. In
particular, economic growth has a strong influence
on the demand for loanable funds, and changes in
the money supply have a strong impact on the
supply of loanable funds