DETERMINATION OF INTEREST RATES

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DETERMINATION OF INTEREST RATES

• OBJECTIVES
• 1. To explain the Loanable Funds Theory of
  interest rate determination
• 2. To identify the major factors affecting the
  level of interest rates
• 3. To discuss the Feds monetary policy tools

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LOANABLE FUNDS THEORY (LFT)

• One of several theories of how the general level
  of interest rates is determined
• Interest rates determined by demand and supply
  for loanable funds
• However, as economic and other factors also
  influence the demand and/or supply level they do
  impact on interest rate

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DEMAND FOR LOANABLE FUNDS

• Households borrow for consumption (auto,
  mortgage, etc)
• Businesses borrow to invest in plant and
  machinery
• Governments borrow to cover budget deficits
  (arising from expenditure exceeding revenues)
• Foreign governments and businesses borrow in
  larger, efficient U.S. financial markets, with
  lower rates
• Government demand is interest inelastic, but all
  other demand curves (on aggregate) slope
  downwards
• Are all components of aggregate consumer spending
  sensitive to interest rates?

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SUPPLY OF LOANABLE FUNDS

• Households are the major suppliers of funds
• Households save from their income to increase
  future consumption
• Rate of savings depends on their preferences for
  current vs. future consumption, level of income,
  amount of wealth, and interest rates
• But is it always the case that higher interest
  rates lead to increased savings i.e., does the
  supply curve have to slope upward?
• Substitution Effect vs. Income Effect
• Businesses also invest (loan) funds temporarily,
  but do interest rates influence the amount they
  save (retain)?

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SUPPLY OF LOANABLE FUNDS

• Government (municipalities, agencies) may also
  supply funds temporarily
• Federal Reserves monetary policy may increase
  money supply - to lower interest rates and
  improve economy
• Does increasing money supply always cause lower
  rates?
• Foreign governments and households are net
  suppliers to the U.S. - induced by interest rate
  differentials
• Overseas inflows are also influenced by expected
  changes in the exchange rate

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GENERAL EQUILIBRIUM INTEREST RATE

• Equilibrium interest rate is that rate at which
  the quantity of aggregate loanable funds demanded
  is equal to the aggregate supply of loanable
  funds
• Means of explaining how economic factors affect
  interest rate levels. How?
• Surplus and shortage conditions impact on the
  equilibrium interest rate

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INTEREST RATE DETERMINATION
Interest Rates
Demand for Loanable Funds
Supply of Loanable Funds
Quantity of Loanable Funds
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OTHER FACTORS AFFECTING RATES

• Changes in demand/supply of loanable funds due to
  level of economic activity
• 1. Increase in demand by businesses due to
  optimistic economic projections leads to
  increased interest rates if there is no
  offsetting increase in supply
• 2. Economic slowdown leads to a decrease in
  demand for loanable funds by firms
• gt Supply may increase as workers save more
  in expectation of worse times. Therefore,
  interest rates are likely to fall

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FACTORS AFFECTING INTEREST RATES

• Inflation and the FISHER Effect
• 1. Lenders want to be compensated for loss of
  purchasing power (inflation)
• 2. Expected increase in inflation leads to higher
  interest rates next period
• 3. Nominal interest rates real interest rate
  expected rate of inflation

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FACTORS AFFECTING INTEREST RATES

• Increased Federal Government Deficit
• 1. Deficit arises when government expenditure
  exceeds its revenues
• 2. Government increases its demand for loanable
  funds Demand curve shifts to the right ?
  interest rates rise
• 3. Supply of funds increases but less than
  increase in government demand
• 4. This leads to crowding out of other
  borrowers
• Deficit spending may improve economy and
  increase savings, thus partially offsetting
  interest rate increase

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FACTORS AFFECTING INTEREST RATES

• Crowding-Out Effect
• Interest Rates
• Increase in government borrowing Supply
• i2
• i1
• 
  Demand2
• Demand1
• Loanable funds
• Crowding out Increase in
  funds

i1
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FACTORS AFFECTING INTEREST RATES

• Influence of Foreign Interest Rates
• 1. Few remaining segmenting barriers between
  major money markets
• 2. Higher (lower) rates in the home market
  attract (discourage) foreign loanable funds,
  hence, decreasing (increasing) interest rates in
  the home market
• 3. Exposure to currency risk impedes the interest
  rate equalization across countries
• Given current economic conditions,
  characterize the (net) flow of funds between the
  U.S.A. and Japan

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FACTORS AFFECTING INTEREST RATES

• Federal Reserve Monetary Policy
• 1. Open market operations affect bank reserves
  which impacts on Fed funds rates, rates on
  loanable funds and rates paid on new deposits by
  financial institutions
• E.g., Low rates on new deposits force
  funds to alternative investments. The latter
  experience reduced interest rates as a result of
  the increase in supply.
• 2. Adjusting the discount rate may influence the
  Fed funds and other market-determined rates. The
  latter also impact on the discount rate
• 3. Adjusting the reserve requirement ratio
  impacts on the supply of loanable funds, hence,
  general interest rates

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