THE DETERMINATION OF THE

LEVEL OF INTEREST RATES

 Objectives of the discussion

At the end of the topic the student must be able to:

1. Define what is interest rate;
2. Discuss the relationship of yield and prices; and
3. Determine interest rate base on classical and neo-classical approach
 INTRODUCTION

The study of interest rates a nd security prices is important

b e c a u s e of the role they play in the allocation of
e c onomic a n d financial resources a nd thus
importance they have for the nation’s standard of
living over time.
 DEFINITIONS AND RELATIONSHIP OF YIELDS
AND PRICES
INTEREST
• for the use of credit or money
• Interaction between the demand for investment capital and the supply of
savings.
• John Maynard Keynes also believed that interest rates were generally set in
the market for loans. Other factors, however, were important: in particular,
the "liquidity preference" of savers.
• The interest rate was determined by the level of reward they demanded for
tying up their money in bonds or other assets rather than keeping it in cash. If
savers believed that prices would fall (including those of financial assets), they
would keep their money firmly under the mattress.
 DEFINITIONS AND RELATIONSHIP OF YIELDS
AND PRICES
INTEREST
• the percentage of an amount of money which is paid for its use for
a specified time
• commonly expressed as an annual percentage rate so as to make it
easy to "compare costs of borrowing money among several
lenders or sellers on credit".
 DEFINITIONS AND RELATIONSHIP OF YIELDS
AND PRICES

Under a contract, the issuer of bond offers to pay an

investigator a fixed amount of interest.
As long as the market price of the bond equals its par value, the coupon
rate equals the security’s yield. But changing supply and demand for
bonds bring about changes in market prices, and bond may:
1. Sell at a premium (in which case market price > par value and the
effective yield < coupon rate)
2. Sell at a discount (in which case market price < par value and the
effective yield > coupon rate)
 DEFINITIONS AND RELATIONSHIP OF YIELDS
AND PRICES
The redemption value, the ultimate obligation of the issuer of
the bond, does not change, but the return (yield) to investors
who buy the b o n d changes if the b o n d price differs from par
value
Bond prices and bond yields vary inversely
Price↑ Yield↓ or Price↓ Yield↑
The higher the price the investors must pay for a given
amount of interest income, the lower their yield or rate of
return.
DEFINITIONS AND RELATIONSHIP OF YIELDS
AND PRICES

𝑃𝑉 = 𝑅/𝑖

Where:
𝑃𝑉 = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒
𝑅 = 𝐵𝑜𝑛𝑑 𝑤𝑖𝑡ℎ 𝑛𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑑𝑎𝑡𝑒
𝑖 = 𝑦𝑖𝑒𝑙𝑑/𝑟𝑎𝑡𝑒 𝑜𝑓 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡
 DEFINITIONS AND RELATIONSHIP OF YIELDS
AND PRICES
An approximate method for determining the yield to maturity is
found in the simple formula:
𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 ± 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑎𝑝𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
𝑖=
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Looking at the “levels” of rate, we might let the average yield on

default-free government bonds serve as a proxy for the rate of
interest.
The use of this rate avoids complexities caused by risk in corporate
bonds, stocks, and real capital assets, and also avoid difficult
problems of measuring yield of a sample of Aaa- rated bonds, since
risk issmall.
 THE CLASSICAL AND NEOCLASSICAL THEORIES OF
THE DETERMINATION OF INTEREST RATES

The Classical Theory

• A d a m Smith – role of the parsimony in fostering e conomi c growth
• Eugen von BohmBawerk – period of production a n d
roundaboutness in the production process
The Neoclassical Theory
• The neoclassical theory differs from classical theory in that it incorporates
major amendments developed by later economists.
• These economist s stressed freedom of choice on the part of those who
save or dissave, given the interest rate that measures the reward,
 THE CLASSICAL AND NEOCLASSICAL THEORIES OF
THE DETERMINATION OF INTEREST RATES
The Neoclassical Theory
• The yield from investment allows them to pay interest out of future
earnings.
• The neoclassical economists views the interest rate as the price that
rations the available supply of saving to borrowers and that induces
suppliers of saving to enter the market.
• Volume of saving depends not only on the interest rate but also on
the income of society.
• Prices are determined by d e m a n d a n d supply.
• Productivity of the real capital assets is the basis for d e m a n d for
investment funds.
 ALTERNATIVE APPROACHES TO THE
DETERMINATION OF THE RATE OF INTEREST
Two alternative theories of the determination of the representative rate
of interest are commonly used.
Liquidity preference theory
• the rate of interest is determined by demand for and supply of money.
• Stock model requiring explanations of motives for holding cash balances and
relating these to the stock of money existing at a given time
Loanable funds theory
• the rate of interest is determined by demand for and supply of loanable funds.
• Commonly stated in a flow form in which demand is the amount which
would be loaned during a period.
 ALTERNATIVE APPROACHES TO THE
DETERMINATION OF THE RATE OF INTEREST
The Liquidity Preference Approach
• Developed out of the writings of John Maynard Keynes in the 1930s as an integral
part of his macroeconomic model income determination
• Stocks theory
• The amount held for transaction varies with the level of economic activity.
• The amount held for precautionary purposes is more or less constant and is not
significantly related to other macroeconomic variables.
• The amount for speculative purposes is inversely related to the level of interest
rates.
 ALTERNATIVE APPROACHES TO THE
DETERMINATION OF THE RATE OF INTEREST

The Liquidity Preference Approach

• If interest rates are high, people attempt to reduce the level of their idle cash
balances and buy interest-earning bonds.
• They also expect that interest rates may fall, meaning that the price of bonds
may rise and they might realize a capital gain.
• At high interest rates, people buy bonds and economize on their cash
balances, running them down to very low levels.
• If interest rates are low, people prefer to hold cash rather than interest-
earning bonds.
 ALTERNATIVE APPROACHES TO THE
DETERMINATION OF THE RATE OF INTEREST

The Liquidity Preference Approach

• This addendum to Keynesian theory was developed by Tobin and Baumol.
• They noted that as income rises and interest rate rise, people begin to
economize on their transaction balances
• The higher the rate of interest, the greater the profit incentive to manage the
checking account balance on a day-to-day basis. Thus, the transactions
demand for money is held to be sensitive to interest rate levels.

𝑀𝐷 = 𝑀(𝑌,i) Liquidity demand for money function

 ALTERNATIVE APPROACHES TO THE
DETERMINATION OF THE RATE OF INTEREST

The Loanable Funds Approach

• Introduces the money supply explicitly
• Preferred by financial analysts because it is more amenable as a
basis for forecasting.
• Simplest and easiest to understand
• Interest rate is determined by the supply of and demand for loanable funds.
• Ask why people lend or borrow for periods of time.
• Flow theory
 ALTERNATIVE APPROACHES TO THE
DETERMINATION OF THE RATE OF INTEREST

The Loanable Funds Approach

Supply of loanable fund is derived from three principal sources
1. Funds are supplied by saving out of income
2. Supply of loanable funds is increased whenever the money supply id
increased
3. Supply of loanable funds may be increased when individuals attempt to
dishoard money, and decreased when attempt to hoard.
 ALTERNATIVE APPROACHES TO THE
DETERMINATION OF THE RATE OF INTEREST

The Loanable Funds Approach

The demand for loanable amount is the result of:
1. Business demand to finance its capital requirements
2. Reflect demand by the federal government for funds as it seeks to finance its
deficits by issuing bonds or other securities and demand by state and local
governments
One defect of the loanable funds theory is that it normally shows a partial or
temporary equilibrium point.
PRICE EXPECTATIONS AND THE RATE OF INTEREST

ṗ
i = r+
p
Where:
i= rate of discount
r= rate of return
ṗ= dt or derivative of the price level
with respect to time
p= price level
 THE FISHER EFFECT

𝑒
ṗ
i = r+
p
• Where the right-hand term no longer describes the results of past inflation but
rather the expected future rate of inflation as indicated by the superscript e
• From early 1930 to the mid-1960s, economists in the United States were not
much interested in the problem of inflation, as it was not very serious
domestically, except in war periods.
 THE FISHER EFFECT

• In the late 1960s and early 1970s, inflation proved to be much more of a
problem. Numerous studies have been made that have focused attention on
the “Fisher effect.”
• The equation showing the “Fisher effect” may be
challenged because:
1. It may not work at all in periods of deflation
2. Proxies foe expectations are unreliable
3. Direct observation of changing expectations, while tempting, may give us an
untestable theory in a scientific sense
 INFLATION IN THE LOANABLE FUNDS MODEL

• Supply a n d d e m a n d for loanable funds to analyze the impact of

inflation on the financial markets.
• Expected proportional rise in all price of ṗ will me an that businessmen will
expect a return on their investmentequal to:
ṗ
i = r+ p
• Borrowers are willing to pay the inflation premium
• Lenders, anticipating inflation, will supply less to the market
INFLATION IN THE LOANABLE FUNDS MODEL

Actual effects of inflation differs because of:

1. Government deficit spending that creates government demand for funds in
not responsive to inflation.
-If prices rise, taxes may increase and the deficit may actually be less if no
offsetting increases in spending occur.
2. When the nominal interest rate rises, above legal maximum rates
paid by some state and local governments, their demand for funds is
restrained.
INFLATION IN THE LOANABLE FUNDS MODEL

• Wealth holders will try to reduce their balances of money when they
anticipateinflation.
• Anticipated inflation lowers consumer confidence in their ability to
consume in the future.
• Institution that collect funds on a steady basis, such as life insurance
companies, supply these funds to the market a n d d o not re du c e their
willingness to lend because of anticipated inflation.
• With ṗ inflation this means that the real interest rate falls and the
p
amount of funds traded in the market increases.
• Only in the long-run would the “Fisher effect” occur fully.
 INTEREST RATE THEORY AT WORK
INTEREST RATE LEVELS IN THE SHORT RUN

• Analysis of nominal interest-rate levels by listing three types of effects:

1. Liquidity effects
2. Income effects
3. Inflationary effects
• In the downturn of the economy, the situation is reversed.
• Consumers may increase the rate at which they save out of disposable income.
• The supply of funds derived from saving increases, and the demand for durable
goods fall.
 INTEREST RATE THEORY AT WORK
INTEREST RATE LEVELS IN THE SHORT RUN

• Reduction in the demand for funds, as business firms begin programs of

retrenchment
• As income falls, this reduction in demand is accompanied by a reduction in
saving and therefore in the supply of funds.
• With the reduction in the supply of funds, interest rates do not fall as far as
they might otherwise.
• As interest rate fall, it may lead to increased hoarding of money and a decline in
the velocity of money, which also occurs as spending is reduced.
 INTEREST RATE THEORY AT WORK
INTEREST RATE LEVELS IN THE LONG RUN

• Over somewhat long periods of time, monetary factors are less important than
those stemming from thrift and productivity.
• Interest-rate levels may show long-term trends when the influence of short-
ru monetary factors is eliminated
• When an economy matures and standards of living rise, the domestic supply of
saving also rises, contributing to an increase in the supply of funds.
• Interest rates tend to fall to more moderate levels if inflation is held under
control.