Lecture 2

Determination of Interest Rates

Angeliki Theophilopoulou

1
Determination of Interest Rates
Outline
 Loanable funds theory
 Economic forces that affect interest rates
 Forecasting interest rates

Reading:
 Madura 2008,ch.2
Additional Reading:
 Inflation Report from Bank of England
 Mishkin & Eakins, ch. 4, 5th edition
 Yvon Fauvel & Alain Paquet & Christian Zimmermann, 1999. "A
Survey on Interest Rate Forecasting," Cahiers de recherche CREFE /
CREFE Working Papers 87, CREFE, Université du Québec à Montréal.

2
Loanable Funds Theory
Loanable funds theory suggests that the market
interest rate is determined by the factors that
affect the supply of and demand for loanable
funds

Can be used to explain movements in the general level

of interest rates of a particular country
Can be used to explain why interest rates among debt
securities of a given country vary

3
Aggregate Demand for Loanable
Funds
Household demand for loanable funds
Households demand loanable funds to
finance:
 Housing
expenditures
 Automobiles
 Household items

There is an inverse relationship between the

interest rate and the quantity of loanable
funds demanded

4
Aggregate Demand for Loanable
Funds (cont’d)
Business demand for loanable funds
Businesses demand loanable funds to invest in fixed assets
and short-term assets
Businesses evaluate projects using net present value (NPV):
n
CFt
NPV  INV 
t 1 (1
 k ) t

 Projects with a positive NPV are accepted

There is an inverse relationship between interest rates and

business demand for loanable funds
5
Aggregate Demand for Loanable
Funds (cont’d)
Government demand for loanable funds
Governments demand funds when planned
expenditures are not covered by incoming revenues
 Municipalities issue municipal bonds (US)
 The government issues Treasury securities

 Gilts are bonds issued by the governments of the United

Kingdom, South Africa, or Ireland.

Government demand for loanable funds is
interest-inelastic

6
UK

Public Sector Net Borrowing
Measured in millions of pounds sterling

7
Aggregate Demand for Loanable
Funds (cont’d)
Foreign Demand for loanable funds

Foreign demand for U.K. funds is influenced by

the interest rate differential between
countries
The quantity of U.K. loanable funds
demanded by foreign governments or firms is
inversely related to U.K. interest rates
The foreign demand schedule will shift in
response to economic conditions
8
Aggregate Demand for Loanable
Funds (cont’d)
Aggregate demand for loanable
funds

The sum of the quantities demanded by the

separate sectors at any given interest rate is
the aggregate demand for loanable funds

9
Aggregate Demand for Loanable
Funds (cont’d)

Dh Db

Household Demand Business Demand

10
Aggregate Demand for Loanable
Funds (cont’d)

Df

Dg

Government Demand Foreign Demand

11
Aggregate Demand for Loanable
Funds (cont’d)

DA

Aggregate Demand

12
Aggregate Supply for Loanable
Funds
Supply of loanable funds

Funds are provided to financial markets by:

 Households (net suppliers of funds)
 Government units and businesses (by a smaller

amount as they are net borrowers of funds)

Suppliers of loanable funds supply more funds

at higher interest rates
13
Aggregate Supply for Loanable
Funds (cont’d)
Supply of loanable funds (cont’d)
Foreign households, governments, and
corporations supply funds by purchasing
domestic corporate and Treasury securities
The supply is influenced by monetary policy
implemented by the Central Bank (BoE)
 TheBoE controls the amount of reserves held by
depository institutions
The supply curve can shift in response to
economic conditions
 Economic growth, taxation etc,.

14
Aggregate Supply for Loanable
Funds (cont’d)
SA

Aggregate Supply

15
Equilibrium of Loanable Funds-
interest rate
Equilibrium interest rate - algebraic
The aggregate demand can be written as

DA  Dh  Db  Dg  Dm  Df

The aggregate supply can be written as

S A  Sh  Sb  Sg  Sm  Sf

16
Equilibrium of Loanable Funds-
interest rate
SA

DA

Equilibrium Interest Rate - Graphic

17
Economic Forces That Affect Interest Rates
Economic growth
Shifts the demand schedule outward (to the
right)
There is no obvious impact on the supply
schedule
 Supply could increase if income increases as a result
of the expansion
The combined effect is an increase in the
equilibrium interest rate

18
Loanable Funds Theory (cont’d)
SA

i2

DA2
DA

Impact of Economic Expansion

19
 Chart 1: GDP projection based on market interest rate
expectations and £200 billion asset purchases

Which factors will affect growth in 2011 for the UK?

From BoE, Inflation report, November 2010 20

Economic Forces That Affect Interest Rates
(cont’d)
Inflationary expectations
Shifts the supply schedule inward (to the left)
 Households increase consumption now if inflation is
expected to increase.
Shifts the demand schedule outward (to the
right)
 Households and businesses borrow more to invest
before prices rise.

21
Loanable Funds Theory (cont’d)
SA2 SA

i2

i
DA2
DA

Impact of Expected Increase in Inflation

22
 Chart 2: CPI inflation projection based on market’s
interest rates expectations and £200 billion asset
purchases

Which factors will affect inflation in 2011 for the UK?

From BoE Inflation Report, November 2010 23

Fed target rate and price of crude
oil

24
Economic Forces That Affect Interest Rates
(cont’d)
Fisher effect
Nominal interest payments compensate savers
for:
Reduced purchasing power

A premium for forgoing present consumption

The relationship between interest rates and

expected inflation is often referred to as the
Fisher effect

25
Economic Forces That Affect Interest
Rates (cont’d)
Fisher effect (cont’d)
Fisher effect equation:

i  E (INF )  i R
The difference between the nominal interest rate and
the expected inflation rate is the real interest rate:
i R  i  E (INF )
Real interest rate more accurately reflects true cost of
borrowing
When real rate is low, greater incentives to borrow and
less to lend

26
Economic Forces That Affect Interest
Rates (cont’d)
Fisher effect (cont’d)
If the actual inflation rate is higher than
anticipated then borrowers benefit :it+1<Et(it+1)
If the actual inflation rate is lower than
anticipated then lenders benefit :it+1 >Et(it+1)

Forecasting inflation is crucial

27
Distinction Between Real
and Nominal Interest Rates
• If i = 3% and E(inflation)= 1% then
• ir = 3% - 1% = 2%

• If i = 3% and E(inflation) = 3.5% then

• ir = 3% - 3.5% = -0.5 %

28
Distinction Between Real
and Nominal Interest Rates

The nominal interest rate shown here is the rate on US government five-year bonds. The inflation rate
represents annual growth in the consumer price index. Source: J.F Nadeau 2009. 29
Economic Forces That Affect Interest Rates
(cont’d)
Money supply
If the CB increases the money supply, the
supply of loanable funds increases
 Ifinflationary expectations are affected, the demand
for loanable funds may also increase

If the CB reduces the money supply, the supply

of loanable funds decreases
The equilibrium interest rate goes up.

30
Money Supply
The total amount of money in the economy at a
particular point of time.
Definition for the UK
M0, monetary base: Cash outside Bank of England +
Banks' operational deposits with Bank of England.
M4, broad money: Cash outside banks (ie. in
circulation with the public and non-bank firms) +
private-sector retail bank and building society
deposits + Private-sector wholesale bank and building
society deposits and Certificate of Deposit.
31
Bank of England Bank Rate

Source: Bank of England 2009 32

Economic Forces That Affect Interest Rates
(cont’d)
Money supply (cont’d)
September 11 2001
 Firms
cut back on expansion plans
 Households cut back on borrowing plans
 The demand of loanable funds declined

The weak economy in 2001–2002

 Reduced demand for loanable funds
 The CB increased the money supply growth
 Interest rates reached very low levels

33
M4 for UK
30

25

20

15

10

0
Oct-82

Oct-83

Oct-84

Oct-86

Oct-88

Oct-89

Oct-90

Oct-91

Oct-93

Oct-95

Oct-97

Oct-98

Oct-00

Oct-02

Oct-04
Oct-85

Oct-87

Oct-92

Oct-94

Oct-96

Oct-99

Oct-01

Oct-03

Oct-05

Oct-06

Oct-07

Oct-08
-5

Series1

3 month growth rate (annualised) of M4

(monetary financial institutions' sterling M4 liabilities to private sector) (in
percent) seasonally adjusted, BoE
34
UK 12 month growth rates of notes and coins
(Seasonally adjusted)

Source: Bloomberg 2009 35

Economic Forces That Affect Interest Rates
(cont’d)
Budget deficit
A high deficit means a high demand for loanable
funds by the government
 Shiftsthe demand schedule outward (to the right)
 Interest rates increase
The government may be willing to pay whatever is
necessary to borrow funds, but the private sector
may not
 Crowding-out effect
 The supply schedule may shift outward if the government
creates more jobs by spending more funds than it collects
from the public (but in a smaller effect)

36
Economic Forces That Affect Interest Rates
(cont’d)
Foreign flows of funds
Shifts in the flows of funds between countries cause
adjustments in the supply of funds available in each
country

37
Economic Forces That Affect Interest Rates
(cont’d)
Explaining the variation in interest rates over time
 Early 1980s: recession led to a decline in interest rates
 Late 1980s: interest rates increased in response to a strong
economy
 Early 1990s: interest rates declined as a result of a weak
economy
 1994: interest rates increased as economic growth increased
 Drifted lower for next several years despite strong economic growth,
partly due to the U.S. budget surplus
 2001: interest rates decreased in response to pessimistic
sentiments for the global economy.
 2008: interest rates fall in historical lows trying to boost the
low economic activity and to combat the credit crunch and
recession.

38 38
CBs’ Monetary Policy (target)
rates

39
 Source:
Chart 1. Net bank lending to PNFCs and households(a) BoE, 2009

(a) Sterling lending excluding the effects of securitisations and loan transfers.
(b) Nominal GDP at market prices in 2009 Q2 is an estimate based on the assumption that nominal GDP falls at the same rate as real GDP as estimated in the preliminary GDP
release.
(c) Recessions are defined as two consecutive quarters of falling output (at constant market prices) estimated using the latest data. The recessions are assumed to end once
output began to rise, apart from the 1970s where two separate occasions of falling output are treated as a single recession.
(d) Sum of: secured lending to households; unsecured lending to households; and lending to unincorporated businesses and non-profit making institutions serving households,
over the periods where data are available.
40
Forecasting Interest Rates
It is difficult to predict the precise change
in the interest rate due to a particular event
Being able to assess the direction of supply or
demand schedule shifts can help in
understanding why rates changed

41
Forecasting Interest Rates (cont’d)
To forecast future interest rates, the net
demand for funds (ND) should be forecast:

ND  DA  S A

 Dh  Db  Dg  Dm  Df 

 Sh  Sb  Sg  Sm S f

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Forecasting Interest Rates (cont’d)
A positive disequilibrium in ND will be
corrected by an increase in interest rates
A negative disequilibrium in ND will be
corrected by a decrease in interest rates

43
 Chart 3: Bank Rate and forward market interest
rates

From BoE Inflation Report, November 2010 44