Financial Markets

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The Money Markets

Module 005 The Money Markets

At the end of this module, you will be able to:

1. Understand the concept and classes of money market
2. Learn the determinants of interest rates
3. Analyses and discuss the security valuation
4. Understand the yields on money market securities

INTRODUCTION

The money market is a well-organized exchange market where people may lend and borrow
short-term, high-quality debt instruments with a one-year or shorter maturity. It enables
governments, banks, and other big organizations to sell short-term securities to meet their
immediate financial needs. Individual investors can also use money markets to invest modest
sums of money in a low-risk environment. Treasury bills, certificates of deposit, commercial
paper, federal funds, bills of exchange, and short-term mortgage-backed securities and asset-
backed securities are among the products traded in the money market.

Large corporations and enterprises with short-term cash flow needs can borrow directly from
the market through their dealer, while small firms with excess cash can borrow through
money market mutual funds. Individual investors can invest in a money market bank account
or a money market mutual fund to profit from the money market. A money market mutual
fund is an expertly managed investment vehicle that acquires money market assets on behalf
of individual investors.

The money market is a sector of the financial market where high-liquidity financial products
with short maturities are exchanged. The money market has evolved into an important part of
the financial market for buying and selling short-term assets such as Treasury bills and
commercial papers with maturities of one year or less. Over-the-counter trading is a
wholesale procedure that takes place in the money market. It is used by the participants as a
short-term borrowing and lending mechanism.

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The Money Markets

Money market is considered a secured market to invest in due to the high liquidity features of
securities. The risks are still present in which investors should be aware of the securities on
default, such as commercial papers. The likes of financial institutions and dealers seek to
borrow or loan securities comprising the money market, and it is one of their best sources to
invest in liquid assets.

The money market is not structured like the capital markets, where securities are arranged
formally. It is a free and informal market. The money market gives a lower return to investors,
but it does provide a wide range of goods. Because of its liquidity, the money market makes it
easy to withdraw money. Money markets are also distinct from capital markets in that they
are designed for short-term securities, whereas capital markets are utilized for long-term
financing.

A mortgage lender can make protection against the risk by entering an agreement with an
agency or private conduit for operational, rather than mandatory, delivery of the mortgage.
For such kind of agreement, the mortgage originator effectively buys an option, which gives
the lender the right, but not the obligation, to deliver the mortgage. Against that, the private
conduit charges a fee for allowing optional delivery. The money market is one of the
important components of the global financial system.

Most money market transactions are wholesale transactions that happen between financial
institutions and companies. Commercial paper is a popular borrowing mechanism in the
wholesale market because the interest rates are relatively higher than for bank time deposits
or Treasury bills and have a wider range of maturities is available, from overnight to 270
days.

The need for money markets arises because individuals, corporations, and governments'
immediate cash needs do not essentially coincide with their receipts of cash. For example,
corporations' daily receipts do not necessarily follow the same pattern as their daily expenses
like wages and other disbursements. Because excessive holdings of cash balances involve a
cost in the form of foregone interest, which is called opportunity cost, those economic units
with surplus cash usually keep such balances to the minimum required to meet their daily
transaction requirements.

Therefore, holders of cash invest excess cash funds in financial securities that can be quickly
and relatively costlessly converted back to cash when needed with minimal risk of loss of
value over the short investment period. Money markets are highly efficient in performing this
service. They allow large amounts of capital to be transferred from suppliers of funds to users
of funds for short periods of time, both quickly and at a low cost to the transacting parties. A
money market instrument provides an investment opportunity that offers a higher rate of
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interest or return than holding cash which yields zero interest, but it is also very liquid and,
due to its short maturity, has relatively low default risk.

It is important to note that money markets and money market securities or instruments have
three basic characteristics. First, money market instruments are mostly sold in large
denominations (often in units of $1 million to $10 million). The majority of the money
market participants resort to borrowing large amounts of cash to have a low transaction cost
and interest paid. The volume of these initial transactions disallows most individual investors
from investing directly in money market securities. Individuals usually invest in money
market securities indirectly through financial institutions such as money market mutual funds
or short-term funds.

Second, money market instruments have low default risk. The risk of late or non-payment of
principal and/or interest is generally small since cash borrowed in the money markets must
be available for a faster return to the lender; money market instruments can generally be
issued only by high-quality borrowers with little risk of default.

Lastly, money market securities must have an original maturity of one year or less. The
longer the maturity of the debt security, the greater its interest rate risk, and the higher is its
required rate of return. Provided that adverse price movements resulting from interest rate
changes are smaller for short-term securities, the short-term maturity of money market
instruments helps reduce the risk that interest rate changes will significantly influence the
security's market value and price.

FUNCTIONS OF THE MONEY MARKET

The money market contributes to economic stability and development by providing short-
term liquidity to governments, commercial banks, and other large businesses.
Here are the main functions of the money market:

• Financing Trade
Local and international merchants in need of short-term capital might turn to the money
market for assistance. It gives the ability to discount bills of exchange, allowing for quick
payment of goods and services. Acceptance houses and discount markets were used by

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international dealers. Other economic units, such as agriculture and small-scale businesses,
can also benefit from the money market.

• Central Bank Policies

The central bank is responsible for a country's monetary policy and allowing measures in
order to keep the financial system healthy and active. Using the money market, the central
bank can efficiently carry out its policy-making duties.

The short-term interest rates on the money market reflect the current state of the banking
industry and can help the central bank create an appropriate interest rate policy. Similarly,
interconnected money markets assist the central bank in influencing sub-markets and
achieving its monetary policy goals.

• Growth of Industries
The money market makes it simple for businesses to get short-term loans to meet their
working capital requirements. Businesses may face cash shortages while purchasing raw
supplies, paying workers, or meeting other short-term expenditures due to the high frequency
of transactions.

They may readily lend money on a short-term basis using commercial paper and finance bills.
Although money markets do not provide long-term loans, they can have an impact on the
capital market and assist businesses in obtaining long-term funding. The money market's
interest rate serves as a benchmark for the capital market's interest rates.

• Commercial Banks Self-Sufficiency

The money market provides a ready market for commercial banks to invest their excess
reserves and earn interest while maintaining liquidity. Bills of exchange and other short-term
investments can be readily converted to cash to enable client withdrawals.

Similarly, when faced with liquidity issues, they might borrow on the money market for a
limited period of time rather than borrowing from the central bank. This has the advantage of
allowing the money market to charge cheaper interest rates on short-term loans than the
central bank.

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The Money Markets

MONEY MARKET INSTRUMENTS

Several financial instruments are created for short-term lending and borrowing in the money
market; they include:

• Treasury Bills
Treasury notes are the most secure instruments since they are issued with a complete
guarantee from the US government. The US Treasury issues them on a regular basis to
refinance maturing Treasury notes and finance the federal government's deficits. They are
available in one, three, six, or twelve month maturities.

Treasury bills are offered at a discount to their face value, and the interest rate is the
difference between the reduced purchase price and the face value. Banks, broker-dealers,
private investors, pension funds, insurance firms, and other major businesses all acquire
them.

• Certificate of Deposit (CD)

A commercial bank issues a certificate of deposit (CD), which may be acquired through
brokerage companies. It can be issued in any denomination and has a maturity date ranging
from three months to five years. Most CDs have a set maturity date and interest rate, and
withdrawals before the maturity date will result in a penalty. A certificate of deposit, like a
bank checking account, is covered by the Federal Deposit Insurance Corporation (FDIC).

• Commercial Paper
Commercial paper is an unsecured loan provided by major firms or corporations to cover
short-term cash flow demands such inventory and accounts payables, as well as working
capital. It is sold at a discount, with the investor profiting from the difference between the
commercial paper's price and face value.

Commercial paper may only be issued by organizations with a high credit rating, making it a
secure investment. Commercial paper is issued in $100,000 and higher denominations.
Individual investors can indirectly participate in the commercial paper market by purchasing
money market funds. Commercial paper has a maturity period ranging from one to nine
months.

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• Banker’s Acceptance
A banker's acceptance is a form of short-term debt issued by a company but guaranteed by a
bank. It is generated by a drawer, providing the bearer the rights to the money specified on its
face at a specified date. It is mostly used in international trade because of the benefits to both
the drawer and the bearer. The holder of the acceptance may choose to sell it on a secondary
market, and investors can profit from the short-term investment. The maturity date usually
lies between one month and six months from the issuing date.

• Repurchase Agreements
A repurchase agreement (repo) is a short-term loan that allows you to sell a securities in
exchange for the right to buy it back at a better price at a later date. It is widely used by
government securities dealers who sell Treasury bills to a lender and then promise to
repurchase them at a later date at a predetermined price. The Federal Reserve buys
repurchase agreements to keep the money supply and bank reserves in check. The maturity
dates of the agreements range from overnight to 30 days or more.

• Money Market Funds

The wholesale money market is restricted to companies and financial institutions that offer
and borrow in amounts ranging from $5 million to well over $1 billion per transaction. Mutual
funds offer baskets of these products to individual investors. This type of fund's net asset
value (NAV) is expected to remain constant at $1. During the 2008 financial crisis, one fund
falling below that level sparked fear in the markets and a huge exodus from the funds,
resulting in further limitations on their access to increasingly riskier investments.

• Money Market Accounts

A sort of savings account, money market accounts are a type of savings account. They offer
interest, but some issuers limit account users' ability to make unscheduled withdrawals or
write checks against the account. The interest on a money market account is usually
calculated daily and credited to the account once a month.

Money market accounts, on average, provide somewhat greater interest rates than traditional
savings accounts. Since the financial crisis of 2008, the rate differential between savings and
money market accounts has decreased considerably. Money market account average interest
rates vary depending on the amount deposited. The best-paying money market account with
no minimum deposit earned 0.99 percent yearly interest as of August 2020.

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• Eurodollars
Eurodollars are dollar-denominated deposits held in foreign banks and are not subject to
Federal Reserve regulations. Very large deposits of Eurodollars are held in banks in the
Cayman Islands and the Bahamas. Money market funds, foreign banks, and large businesses
invest in them because they pay a slightly higher interest rate than U.S. government debt.

DETERMINANTS OF INTEREST RATE

The cost of borrowing money is represented by the interest rate. To put it another way,
there's a trade-off between the service's value and the danger of lending money. In both
situations, it boosts the economy by encouraging individuals to borrow, lend, and spend. The
present interest rate, on the other hand, is always changing, and different types of loans have
varying interest rates. Whether you're a lender, a borrower, or both, it's critical that you
understand why these variations and changes exist. They have a significant influence on the
stock markets for rare metals and silver.

The practice of charging interest on money loans has not always been considered appropriate.
Both the Bible and Shari'ah law expressly forbid "Usury," and current Islamic banks exist only
for the purpose of profit.

The distinctions between interest, rent, profit, and capital appreciation in modern financial
markets are not obvious. The present trend and fascinating suggestion on interest taxes in the
European Union has highlighted the difficulties of arriving at legally exact definitions. Interest
is the cost of persuading individuals with money to save rather than spend it, and to invest in
long-term assets rather than cash, according to economic theory. The Rates are a reflection of
the relationship between the supply of savings and demand for the fund, or the demand for
and supply of money.

Interest rates are expressed as a percentage payable or a coupon; commonly, they are
expressed yearly; or as the present discounted value of an amount payable at a future date,
usually the maturity date. There is an inverse connection between the current interest rate
and the discounted value of assets paying interest at any given period. Bond prices, for
example, decline when yields rise.

The distinction between "nominal" and "real" interest rates must be understood. The nominal
or "coupon" rate is subtracted from the rate at which money depreciates in value to get a real
interest rate. Because there are so many different ways to calculate inflation rates, computing
actual rates is a methodological challenge.

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Inflationary expectations, however, are one of the most vital determinants of interest rates.
Generally, investors demand a real return from their investments. Changes in the forecasts of
future inflation are therefore reflected in the current prices of assets. The effect on bonds of
varying maturity, for example, can be charted as shifts in the "yield curve".

Different levels of risk are also reflected in interest rates. A company with a good credit rating,
such as the European Investment Bank, will be able to draw savings at a considerably lower
rate of interest than "junk bond" issuers. Those with a high amount of existing debt may have
to pay higher borrowing rates than countries with a low risk of default. Certainly, the
assurance that "sovereign debt" will be repaid on maturity has allowed governments to
borrow at negative real rates of interest on a number of occasions.

Short-term Rates
The rates established by Central Banks have a significant impact on money market
"overnight" (up to a week) and "short-term" (up to a year) interest rates. The European
System of Central Banks (ESCB) can utilize its monopoly cash supply authority to establish a
"floor" and "limit" for overnight and short rates (the Deposit Rate and the Marginal Lending
Rate), as well as a benchmark central rate, throughout the euro region (the Marginal
Refinancing Rate or "repo" rate).

Short-term rates will be set by central banks with primary responsibility for price stability,
such as the European Central Bank (ECB), in order to avoid future inflation. Higher current
rates should encourage consumers to save rather than spend, as well as firms to postpone
capital expenditures. "Neutral" interest rates will be just high enough to keep future inflation
at bay, but not so high as to stifle economic development and lead to job losses.

There are a number of problems in implementing this theoretical model, however.

• Political support for the goal of price stability isn't assured. Maintaining full
employment, for example, might be an alternate goal, with interest rates kept low to
encourage investment. Alternatively, nominal rates may only be modified to keep real
rates at a certain level.

• Determining what "neutral" rates are at any one time is difficult, if not impossible.
Using data of different precision to estimate inflationary risk is a question of judgment.
The ECB uses a "twin pillar" approach, with a 4.5 percent reference level for
annualized growth in the monetary aggregate M3 and a "broadly based assessment of

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the outlook for price developments" based on a variety of other indicators such as
bond yields, consumer credit, and the exchange rate, among others.

• The transmission mechanisms through which Central Bank interest rates flow into
market rates are unknown. Disparities in corporate financing sources, the quantity and
structure of business and household debt, and the degree of competition in the
financial services industry cause differences between national economies and regions.
Because financial systems are now in flux as a result of monetary unification, nothing
can be learned from previous experience (the Lucas critique).

• International financial markets are increasingly influencing national economies.

Short-term capital can migrate quickly across currency regions in pursuit of greater
returns, causing domestic monetary policy to be disrupted. This can lead to conflicts
like the one that the United Kingdom encountered in September 1992, when higher
interest rates were needed to avoid a devaluation of the pound sterling and maintain it
within the European Monetary System's Exchange Rate Mechanism lower rates to
avoid a recession. In compared to the individual Member States' currency regions, the
euro area has a lower share of GDP that is exchanged, which has decreased, but not
eliminated, such vulnerability.

Long-term Rates

Global financial markets' presence ensures that real long-term interest rates tend to move
together in various economies. However, nominal long-term rates reflect inflationary
expectations in the separate economies, which in turn reflect the credibility of domestic
monetary policy. Connected to inflationary expectations are exchange-rate expectations;
however, exchange-rate movements can also take place for reasons unconnected to inflation
differentials. Economic theory in this area has a bad record of the forecast.

The outcome of short-term interest rate changes on long-term rates is not, therefore,
straightforward. An increase in short-term rates can lead to, or be contemporary with, a rise
in long rates and a fall if the markets are influenced that future inflation has been prevented.

National fiscal policies have also played a major part in determining long-term interest rates.
Where budget shortages and/or the total government debt level have been high, the need to
borrow for current spending and refinance maturing debt has forced up long-term rates. The
path of "monetization" like the printing money to meet current budget deficits, allowing
inflation to reduce the real value of existing debt, has led to borrowing at ever-higher rates of
interest, and ever-shorter maturities, with default at the end. For this motive, the Maastricht
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Treaty clauses, strengthened by the Stability and Growth Pact, demand balanced budgets
throughout the economic cycle and outright ban monetization, preferential access to funds,
and "bail-out" of failing public entities. All euro zone members are committed to bringing their
total public debt down to 60% of GDP or less.

The extent to which interest rate fluctuations impact the actual economy, including
investment, GDP, employment, and other factors, is also unclear. An increase in rates, in
general, has a negative effect on future GDP, and a fall in rates a positive one. But the effects in
detail rely on the structure of a particular economy and the components of demand within it.
The latest Japanese experience shows that very low rates of interest, on their own, are not
enough to revive a lagging economy.

The interest rates observed in financial markets are known as nominal interest rates. These
nominal interest rates, or simply interest rates, have a direct impact on the value (price) of
most assets traded in the domestic and international money and capital markets.

LOANABLE FUNDS THEORY

Interest rates play a vital role in the determination of the value of financial instruments. For
example, when the Fed suddenly raised interest rates in February 2010, financial markets
reacted significantly. The Dow Jones Industrial Average, which had previously posted three
consecutive days of gains in value, dropped 0.9 percent in value, the yield on Treasury
securities increased, which is the yield on two-year T-notes improved from 0.88 percent to
0.92 percent, gold prices dropped $11 to $1,112.70, and the U.S. dollar weakened against
foreign currencies (the dollar fell from $1.3613/€ to $1.3518/€).

Given the effect a change in interest rates has on security values, financial institutions and
other financial managers spend much time and effort trying to identify factors that dictate the
level of interest rates at any moment in time and what causes interest rate movements over
time.

One commonly used model to explain interest rates and interest rate movements is the
loanable funds theory. The loanable funds theory of interest rate determination views the
level of interest rates in financial markets as resulting from factors that affect the supply, for
example, from households, and demand, for example, from corporations for loanable funds.
This is similar to how the prices for goods and services, in general, are viewed as the result of
the forces of supply and demand for those goods and services. The supply of loanable funds is
commonly used to describe funds provided to the financial markets by net suppliers. The
demand for loanable funds is used to describe the total net demand for fund users' funds.
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The loanable funds framework categorizes financial market participants, suppliers, and
demanders of funds as consumers, businesses, governments, and foreign participants. The
loanable funds theory is a theory of interest rate determination that views equilibrium
interest rates in financial markets as a result of the supply and demand for loanable funds.

Supply of Loanable Fund

Generally, the quantity of loanable funds supplied increases as interest rates rise. Figure
below illustrates the supply curve for loanable funds. Other factors are held constant; more
funds are supplied as interest rates increase (the reward for supplying funds is higher).

The household sector, also known as the consumer sector, is the biggest supplier of loanable
funds in the United States—$45.54 trillion in 2010. Households supply funds when they have
surplus income or want to transfer their asset portfolio holdings. For instance, during high
economic growth times, households may substitute part of their cash holdings with earning
assets, for example, by providing loanable funds in exchange for holding securities. The entire
quantity of loanable money from a customer will typically rise as that consumer's total wealth
increases. Households select their supply of loanable money based on the risk of securities
investments as well as the general level of interest rates and their total wealth.

At each interest rate, fewer consumers are ready to invest because of the perceived risk of
securities investments. Furthermore, the availability of loanable cash from families is
influenced by their immediate spending demands. For example, near-term schooling or
medical expenses will deplete a household's financial resources.

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Source: Financial Markets and Institutions, 5th edition, page 38.

Higher interest rates will also result in more funds being supplied by the US business sector
($17.71 trillion from nonfinancial businesses and $43.34 trillion from financial businesses in
2010), which frequently has excess cash or working capital that it can invest in financial
assets for a short period of time. Aside from interest rates, the projected risk on financial
assets and their enterprises' future investment needs will have an impact on their overall
availability of money.

Some governments also provide loanable money ($18.62 trillion in 2010). Some governments
(for example, municipalities) may temporarily produce more revenue inflows (for example,
from local taxes) than they have budgeted to spend. These funds can be lent to users of
financial market funds until they are needed.
Finally, international investors increasingly see U.S. financial markets as a substitute for their
local financial markets, with $15.63 trillion in money flowing into them in 2010. Foreign
investors boost their supply of money to U.S. markets when interest rates on U.S. financial
assets are greater than equivalent securities in their home nations. Indeed, foreign
households' high savings rates (such as Japanese households) have resulted in foreign market
participants being major suppliers of funds to U.S. financial markets in recent years. Like
domestic suppliers of loanable funds, foreigners assess the interest rate offered on financial
securities and their total wealth, the risk on the security, and their future expenditure needs.

Furthermore, if financial conditions in their home countries change in relation to the US

economy and the exchange rate of their country's currency changes against the US dollar,
international investors adjust their investment selections. During the current financial crisis,
for example, investors all over the world sought a safe refuge for their money and poured
billions of dollars into U.S. Treasury securities. The quantity of money invested in Treasury

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notes was so great that the three-month Treasury bill yield fell below zero for the first time
ever, implying that investors were effectively paying the US government to borrow money.

Source: Financial Markets and Institutions, 5th edition, page 39.

Demand for Loanable Funds

In general, the quantity of loanable funds demanded is higher as interest rates decrease. The
figure above also illustrates the demand curve for loanable funds. Other factors are held
constant; more funds are demanded as interest rates fall (the cost of borrowing funds is
lower). Households (though they are net suppliers of funds) also lend funds in financial
markets ($20.50 trillion in 2010). The demand for loanable funds by households reflects the
demand for financing purchases of homes (with mortgage loans), durable goods (e.g., car
loans, appliance loans), and nondurable goods (e.g., education loans, medical loans).
Additional non-price conditions and requirements also affect a household’s demand for
loanable funds at every level of interest rates.

Businesses typically issue debt and other financial instruments to finance long-term (fixed)
assets (e.g., plant and equipment) as well as short-term working capital needs (e.g., inventory
and accounts receivable) ($41.71 trillion for nonfinancial businesses and $60.10 trillion for
financial businesses in 2010). Businesses prefer to finance investments using internally
produced money (e.g., retained earnings) rather than borrowed funds when interest rates are
high (i.e., the cost of loanable funds is high).

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Furthermore, the higher the demand for loanable money, the bigger the quantity of profitable
projects accessible to firms or the better the general economic conditions. Governments also
take out a lot of loans in the market ($12.07 trillion in 2010). State and municipal
governments, for example, frequently issue debt instruments to cover short-term gaps
between operational income (e.g., taxes) and projected expenditures (e.g., road
improvements, school construction). Higher interest rates may force state and municipal
governments to delay borrowing and, as a result, capital spending. Governments' demand for
cash fluctuates with overall economic conditions, much like families and companies. The
federal government is also a significant borrower, partially to cover current budget deficits
(expenditures exceeding revenues) and partly to cover historical deficits. The national debt is
the total of historical deficits, which in the United States reached a new high of $14.34 trillion
in 2011.

Thus, the national debt and the interest payments on the national debt have to be financed
largely by additional government borrowing. Chapter 4 provides details of how government
borrowing and spending impact interest rates as well as overall economic growth.

Finally, international players (households, corporations, and governments) borrowed $6.46

trillion in 2010 in US financial markets. Foreign borrowers search the world for the lowest
dollar funds. The business sector accounts for the majority of foreign borrowing in US
financial markets. Foreign borrowers evaluate non-price terms on loanable money, as well as
economic conditions in their home nation and the dollar's general desirability relative to their
native currency, in addition to interest charges (e.g., the euro or the yen).

Factors That Cause the Supply and Demand Curves for Loanable Funds to Shift
While we've hinted at the underlying causes that drive the supply and demand curves for
loanable money to fluctuate, this section officially summarizes them. The equilibrium interest
rate of a given financial instrument is then determined by variations in the supply and
demand curves for loanable funds. When the quantity of financial security provided or desired
varies at each given interest rate in reaction to a change in another element other than the
interest rate, this is known as a shift in the supply or demand curve. In either scenario, a shift
in the supply or demand curve for loanable funds causes interest rates to shift.

Supply of Funds
We have already described the positive relationship between interest rates and loanable
funds' supply along the loanable funds supply curve. Factors that cause the supply curve of
loanable funds to shift at any given interest rate include the wealth of fund suppliers, the risk

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of financial security, future spending needs, monetary policy objectives, and economic
conditions.

• Wealth
As the total wealth of financial market participants (households, businesses, etc.) increases,
the absolute dollar value available for investment purposes increases. Accordingly, the supply
of loanable funds increases at every interest rate, or the supply curve shifts down and to the
right. For example, as the U.S. economy grew in the mid-2000s, the total wealth of U.S.
investors increased as well. On the other hand, as the total wealth of financial market
participants declines, the absolute dollar value available for investment purposes declines.
Therefore, the supply of loanable funds drops at every interest rate, or the supply curve shifts
up and to the left. The fall in the supply of funds due to a decline in market participants' total
wealth results in the rise in the equilibrium interest rate and a fall in the equilibrium quantity
of funds loaned (traded).

• Risk
As the risk of a financial security decreases (e.g., the probability that the issuer of the security
will default on promised repayments of the funds borrowed), it becomes more attractive to
suppliers of funds. Conversely, as the risk of financial security increases, it becomes less
attractive to suppliers of funds. Accordingly, the supply of loanable funds declines at every
interest rate, or the supply curve shifts up and to the left. Holding all other factors constant,
the decrease in the supply of funds due to an increase in the financial security's risk increases
the equilibrium interest rate and a fall in the equilibrium quantity of funds loaned (or traded)
• Near-Term Spending Needs

When financial market participants have few near-term spending needs, the absolute dollar
value of funds available to invest increases. For example, when a family's son or daughter
moves out of the family home to live on his or her own, the family's current spending needs
decrease, and the supply of available funds (for investing) increases. The supply of loanable
funds increases at every interest rate, or the supply curve shifts down and to the right. The
financial market, holding all other factors constant, reacts to this increased supply of funds by
decreasing the equilibrium interest rate and increasing the equilibrium quantity of funds
traded. Conversely, when financial market participants have increased near-term spending
needs, the absolute dollar value of funds available to invest decreases. The supply of loanable
funds decreases at every interest rate, or the supply curve shifts up and to the left. The supply
curve shift creates a disequilibrium in the financial market that increases the equilibrium
interest rate and decreases the equilibrium quantity of funds loaned (or traded).

• Monetary Expansion
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When monetary policy objectives are to allow the economy to expand (as was the case in the
late 2000s, during the financial crisis), the Federal Reserve increases the supply of funds
available in the financial markets. At every interest rate, the supply of loanable funds
increases, the supply curve shifts down and to the right, and the equilibrium interest rate falls,
while the equilibrium quantity of funds traded increases. Conversely, when monetary policy
objectives are to restrict the rate of economic expansion (and thus inflation), the Federal
Reserve decreases the supply of funds available in the financial markets. At every interest
rate, the supply of loanable funds decreases, the supply curve shifts up and to the left, and the
equilibrium interest rate rises, while the equilibrium quantity of funds loaned or traded
decreases.

• Economic Conditions
Finally, as the underlying economic conditions themselves (e.g., the inflation rate,
unemployment rate, economic growth) improve in a country relative to other countries, the
flow of funds to that country increases. This reflects the lower risk (country or sovereign risk)
that the country, in the guise of its government, will default on its obligation to repay funds
borrowed. For example, the severe economic crisis in Argentina in the early 2000s resulted in
a decrease in the country's supply of funds. An increased inflow of foreign funds to U.S.
financial markets increases the supply of loanable funds at every interest rate, and the supply
curve shifts down and to the right. Accordingly, the equilibrium interest rate falls, and the
equilibrium quantity of funds loaned or traded increases. Conversely, when foreign countries'
economic conditions improve, domestic and foreign investors take their funds out of domestic
financial markets (e.g., the United States) and invest abroad. Thus, the supply of funds
available in the financial markets decreases, and the equilibrium interest rate rises, while the
equilibrium quantity of funds traded decreases.

Demand for Funds

In the previous section, we learned that a firm's decision to acquire and keep capital depends
on the net present value of the capital in question, which in turn depends on the interest rate.
The lower the interest rate, the greater the amount of capital that firms will want to acquire
and hold since lower interest rates translate into more capital with positive net present
values. The desire for more capital means, in turn, a desire for more loanable funds. Similarly,
at higher interest rates, less capital will be demanded because more of the capital in question
will have negative net present values. Higher interest rates, therefore, mean less funding
demanded.

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Figure 1: The Demand and Supply of Loanable Funds. At lower interest rates, firms demand more capital
and, therefore, more loanable funds. The demand for loanable funds is downward-sloping. The supply of
loanable funds is generally upward-sloping. The equilibrium interest rate, rE, will be found where the two
curves intersect.

Source: https://courses.lumenlearning.com/

Thus the demand for loanable funds is downward-sloping, like the demand for
virtually everything else, as shown in Figure 1. The lower the interest rate, the more capital
firms will demand. The more capital that firms demand, the greater the funding that is
required to finance it.

FACTORS AFFECTING NOMINAL INTEREST RATES

Inflation —the continual increase in the price level of a basket of goods and services.
Real Interest Rate —a nominal interest rate that would exist on security if no inflation were
expected. Default Risk —risk that a security issuer will default on the security by missing
interest or principal payment.

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Liquidity Risk —risk that a security cannot be sold at a predictable price with low
transaction costs at short notice.

Special Provisions —provisions (e.g., taxability, convertibility, and callability) that impact
the security holder beneficially or adversely and, as such are reflected in the interest rates on
securities that contain such provisions.

Term to maturity —length of time a security has until maturity.

Inflation

The first factor to affect interest rates is the actual or expected inflation rate in the economy.
Specifically, the higher the level of actual or expected inflation, the higher the level of interest
rates will be. The intuition behind the positive relationship between interest rates and
inflation rates is that an investor who buys a financial asset must earn a higher interest rate
when inflation increases to compensate for the increased cost of foregoing consumption of
real goods and services today and buying these more highly priced goods and services in the
future. In other words, the higher the rate of inflation, the more expensive the same basket of
goods and services will be in the future. Inflation of the general price index of goods and
services (I.P.) is defined as the (percentage) increase in the price of a standardized basket of
goods and services over a given period of time. In the United States, inflation is measured
using indexes such as the consumer price index (CPI) and the producer price index (PPI). For
example, the annual inflation rate using the CPI index between years t and t ! 1 would be equal
to:

Real Interest Rates

A real interest rate is the interest rate that would exist on security if no inflation were
expected over the holding period (e.g., a year) of security. The real interest rate on an
investment is the percentage change in the buying power of a dollar. As such, it measures
society's relative time preference for consuming today rather than tomorrow. The higher

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society's preference to consume today (i.e., the higher its time value of money or rate of time
preference), the higher the real interest rate (RIR).

Fisher Effect

The relationship among the real interest rate (RIR), the expected rate of inflation [Expected
(I.P.)], described above, and the nominal interest rate ( i ) is often referred to as the Fisher
effect, named for the economist Irving Fisher, who identified these relationships early last
century. The Fisher effect theorizes that nominal interest rates observed in financial markets
(e.g., the one-year Treasury bill rate) must compensate investors for (1) any reduced
purchasing power on funds lent (or principal lent) due to inflationary price changes and (2)
an additional premium above the expected rate of inflation for forgoing present consumption
(which reflects the real interest rate discussed above). When an investor purchases a security
that pays interest, the nominal interest rate exceeds the real interest rate because of inflation.

where RIR $ Expected (I.P.) is the inflation premium for the loss of purchasing power on the
promised nominal interest rate payments due to inflation. For small values of RIR and
Expected (I.P.) this term is negligible. Thus, the Fisher effect formula is often written as:

The approximation formula assumes RIR $ Expected (I.P.) is small. Thus, the nominal interest
rate will be equal to the real interest rate only when market participants expect the inflation
rate to be zero—Expected (I.P.) " 0. Similarly, nominal interest rates will be equal to the
expected inflation rate only when real interest rates are zero. Note that we can rearrange the
nominal interest rate equation to show the determinants of the real interest rate as follows:

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EXAMPLE: Calculations of Real Interest Rates

The one-year Treasury bill rate in 2007 averaged 4.53 percent, and inflation (measured by the
consumer price index) for the year was 4.10 percent. If investors had expected the same
inflation rate as that actually realized (i.e., 4.10 percent), then according to the Fisher effect,
the real interest rate for 2007 was:

4.53% - 4.10% = 0.43%

The one-year T-bill rate in 2009 was 0.47 percent, while the CPI for the year was 2.70 percent.
This implies a real interest rate of −2.23 percent; that is, the real interest rate was negative.

INTERNATIONAL ASPECTS OF MONEY MARKETS

Euro Money Markets

Large banks in London organized the interbank Eurodollar market. This market is now
utilized by banks around the world as a source of overnight funding. The term "Eurodollar
market" is something of a contradiction because the markets have no true physical location.
Rather, the Eurodollar market is a market in which dollars held outside the United States are
traced among multinational banks, including the offices of U.S. banks abroad, such as
Citigroup's branch in London or its subsidiary in London. For example, a corporation in Italy
requiring U.S. dollars for a foreign trade transaction might ask Citigroup's subsidiary in
London to borrow these dollars on the Eurodollar market. Otherwise, a Greek bank needing
U.S. dollar funding may raise the required funds by issuing a Eurodollar CD. Most Eurodollar
transactions take place in London.

London Interbank Offered Rate (LIBOR)

The rate offered for sale on Eurodollar funds is commonly known as the London Interbank
Offered Rate (LIBOR). The funds traded in the Eurodollar market are mostly used as an
alternative to fed funds as a source of overnight funding for banks. As alternate sources of
overnight funding, the LIBOR and the U.S. federal funds rate likely to be very closely related. If
rates in one of these markets like the LIBOR market decrease relative to the other like the fed

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funds market, the overnight borrowers will borrow in the LIBOR market rather than the fed
funds market. As a result, the LIBOR will increase with this upsurge demand, and the fed
funds rate will decline with the decrease in demand. This will make the difference between
the two rates pretty small, although not equal. The convenience of transacting in both markets
makes it virtually costless to use one market versus the other. Certainly, the LIBOR rate is
mostly used by major banks in the United States to base commercial and industrial loans.

Books and Journals

Saunders, A. and Cornett, M. (2016). Financial Markets and Institutions, The McGraw-
Hill Inc. New York
Hubbard, G. and O’brien, A. (2017). Money, Banking, and the Financial System, Prentice
Hall, Prentice Hall, One Lake Street, Upper Saddle River, NJ 07458
Boumediene, N. and Coelho da Rocha, L. (2016) INTERNATIONAL CORPORATE
FINANCE, Leaders League SAS, Paris: B422 584 532
Krugman, P. and Obstfeld, M. (2018) International Finance: THEORY & POLICY (11th
Ed.), Pearson Education Limited, United Kingdom, ISBN 10: 1-292-23873-9

Online Supplementary Reading Materials

https://corporatefinanceinstitute.com
https://www.investopedia.com
https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/what-is-
money-market/
https://www.europarl.europa.eu/workingpapers/econ/116/116_en.htm

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