Topic 3 Determination of Interest Rates

Chapter Objectives

• Apply the interest rate theories to explain why

interest rates change.
• Identify the most relevant factors that affect
interest rate movements.

**Ref: Chap 2 & 3 in textbook

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1
 1)Loanable Funds Theory (1 of 8)

• The Loanable Funds Theory suggests that the market

interest rate is determined by the factors that control
supply of and demand for loanable funds.
• 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

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 Loanable Funds Theory (2 of 8)

Household Demand for Loanable Funds

• Households demand loanable funds to finance housing
expenditures as well as the purchase of automobiles
and household items.
• Inverse relationship (Exhibit 2.1: Relationship between Interest
Rates and Household Demand (Dh) for Loanable Funds at a Given Point
in Time)

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 Loanable Funds Theory (3 of 8)

Business Demand for Loanable Funds

• Businesses will demand a greater quantity of loanable
funds at a given point in time if interest rates are lower.

• (Exhibit 2.2 :Relationship between Interest Rates and Business Demand (Db)
for Loanable Funds at a Given Point in Time)

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 Loanable Funds Theory (4 of 8)

Government Demand for Loanable Funds

• Governments demand loanable funds when planned expenditures are not covered by
incoming revenues.
• Government demand is said to be interest inelastic — insensitive to interest rates.
Expenditures and tax policies are independent of the level of interest rates.

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 Loanable Funds Theory (5 of 8)

Foreign Demand for Loanable Funds

• A country’s demand for foreign funds depends on
on the IR differential between the two.
• The greater the differential, the greater the
demand for foreign funds.
• The quantity of U.S. loanable funds demanded by
foreign governments will be inversely related to
U.S. interest rates. (Exhibit 2.4)
Aggregate Demand for Loanable Funds
• The sum of the quantities demanded by the separate
sectors at any given interest rate. (Exhibit 2.5)

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 Exhibit 2.5 Determination of the Aggregate
Demand Curve for Loanable Funds

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 Loanable Funds Theory (6 of 8)

Supply of Loanable Funds

• Households are largest supplier, but some supplied by
government units.
• More supply at higher interest rates.
• Supply by buying securities.
• Effects of the Fed — By affecting the supply of loanable
funds, the Fed’s monetary policy affects interest rates.
• Aggregate supply of funds — Is the combination of all
sector supply schedules along with the supply of funds
provided by the Fed’s monetary policy. (Exhibit 2.6)

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 Exhibit 2.6 Aggregate Supply Curve for
Loanable Funds

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 Loanable Funds Theory (7 of 8)

Equilibrium Interest Rate – Algebraic Presentation

• Aggregate Demand for funds (DA)
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
• Aggregate Supply
Df = foreign demandof
forfunds
loanable(S A)
funds
SA = S h + S b + S g + S m + S f
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
S = foreign supply for loanable funds
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 Loanable Funds Theory (8 of 8)

Equilibrium Interest Rate — Graphical Presentation

• Combining aggregate demand and aggregate supply
curves (Exhibits 2.5 and 2.6) allows comparison of
total amount demanded to total amount supplied
• At equilibrium interest rate i, the supply of loanable
funds is equal to the demand for loanable funds.
(Exhibit 2.7)
• At interest rate above i, there is a surplus of loanable
funds.
• At interest rate below i, there is a shortage of
loanable funds.

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 Exhibit 2.7 Interest Rate Equilibrium

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 Factors That Affect Interest Rates (1 of 3)

Impact of economic growth on interest rates:

• Puts upward pressure on interest rates by shifting demand
for loanable funds outward. (Exhibits 2.8 & 2.9)

Impact of inflation on interest rates:

• Puts upward pressure on interest rates by shifting supply of
funds inward and demand for funds outward. (Exhibit 2.10)
• Fisher effect: i = E(INF) + iR

where i = nominal or quoted rate of interest

E(INF) = expected inflation rate
iR = real interest rate

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 Exhibit 2.8 Impact of Increased Expansion
by Firms

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 Exhibit 2.9 Impact of an Economic
Slowdown

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 Exhibit 2.10 Impact of an Increase in
Inflationary Expectations on Interest Rates

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 Factors that Affect Interest Rates (2 of 3)
Impact of Monetary Policy on Interest Rates
When the Fed reduces (increases) the money supply, it
reduces (increases) the supply of loanable funds, putting
upward (downward) pressure on interest rates. (Exhibit 2.11)
Impact of the Budget Deficit on Interest Rates
Crowding-out Effect: Given a certain amount of loanable
funds supplied to the market, excessive government demand
for funds tends to “crowd out” the private demand for funds.
(Exhibit 2.12)
Impact of Foreign Flows of Funds on Interest Rates
Interest rate for a certain currency is determined by the
demand for funds in that currency and the supply of funds
available in that currency. (Exhibit 2.13)

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 Exhibit 2.11 U.S. Interest Rates Over Time

Note: Rate shown is for Treasury bills with a one-year maturity. The shaded area
represents a recession period.
Source: Board of Governors of the Federal Reserve.

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 Exhibit 2.12 Flow of Funds between the
Federal Government and the Private Sector

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 Interest Rate vs Term Structure

2) Pure Expectations Theory

• According to pure expectations theory, the term structure of interest
rates is determined solely by expectations of interest rates.
• Impact of an Expected Increase in Interest Rates (Exhibit 3.3)
• Impact of an Expected Decline in Interest Rates (Exhibit 3.3)
• Algebraic Presentation — If the term structure of interest rates
is solely influenced by expectations of future interest rates, the
following relationships hold:
SCENARIO STRUCTURE OF EXPECTATIONS ABOUT THE
YIELD CURVE FUTURE INTEREST RATE
1. t+1 r1 > ti1 Upward slope Higher than today’s rate
2. t+1 r1 = ti1 Flat Same as today’s rate
3. t+1 r1 < ti1 Downward slope Lower than today’s rate

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 Exhibit 3.3 How Interest Rate Expectations
Affect the Yield Curve

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 A Closer Look at the Term Structure (2 of 7)

Pure Expectations Theory (continued)

Algebraic Presentation (continued)
According to pure expectations theory, a one-year
investment followed by a two-year investment should offer
the same annualized yield over the three-year horizon as a
three year security that could be purchased today. This
relation is expressed as follows:

1  t i3   1  t i1 1  t 1 i2 
3 2

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 IR vs Term Structure (cont’)

3) Liquidity Premium Theory(Exhibit 3.4)

• The preference for the more liquid short-term
securities places upward pressure on the slope
of a yield curve. Liquidity may be a more critical
factor to investors at some times than at others,
and the liquidity premium will accordingly
change over time.
• The model that explains these movements is
called liquidity premium theory

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 Exhibit 3.4 Impact of Liquidity Premium on the
Yield Curve under Three Different Scenarios

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 IR vs Term Structure (cont’)

4)Segmented Markets Theory: Investors choose

securities with maturities that satisfy their
forecasted cash needs.
• Limitation of the Theory:
• Some borrowers and savers have the flexibility to
choose among various maturities.
• Implications: Preferred Habitat Theory
• Although investors and borrowers may normally
concentrate on a particular maturity market, certain
events may cause them to wander from their “natural”
or preferred market.

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