Chapter 6 Determining Interest Rates

1
Chapter 6Determining Interest Rates
2
Abstractions

• Economists abstract from inessentials to focus on
  key aspects
• In reality, there are a great many interest rates
• Key abstraction a single interest rate i
• i should be thought of as the average level of
  nominal interest rates
• Given only one interest rate, there can be only
  one type of bond

3
Market for Loanable Funds

• This bond is traded in a competitive market
• Savers in this market are said to supply loanable
  funds
• Borrowers in this market are said to demand
  loanable funds
• And the bond market itself is said to be the
  market for loanable funds

4
Supply of Loanable Funds

• Savers make choices about how much wealth to hold
  as bonds
• The most important determinant of this choice is
  the expected rate of return on bonds i.e. the
  interest rate i
• The higher i is, the more bonds they wish to hold
  and thus the more loanable funds they supply

5
Result Upward SlopingSupply for Loanable Funds
i
S
i2
i1
l
l1
l2
6
Demand for Loanable Funds

• Borrowers make choices about how much capital to
  have and how to finance it
• The most important determinant of this choice is
  the expected rate of return on bonds i.e. the
  interest rate i
• The higher i is, the less capital they wish to
  hold, the fewer bonds they wish to issue, and the
  less loanable funds they demand

7
Result Downward SlopingDemand for Loanable Funds
i
i3
i4
D
l
l3
l4
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Conditions for Equilibrium

• Savers are supplying as much loanable funds as
  they wish
• Borrowers are demanding as much loanable funds as
  they wish
• The interest rate is at the level that equates
  the amount of loanable funds supplied to the
  amount demanded, thereby making savers and
  borrowers choices consistent with each other

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Equilibrium
i
S
i
D
l
l
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Why Equilibrium?
i
i
S
S
i?
i
i
i?
D
D
l
l
l?
l
l?
l
l??
l??
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Explaining Interest-Rate Changes

• The model is useful largely because it tells how
  the rest of the economy affects the average level
  of the nominal interest rate
• It lets us distinguish influences operating
  through supply from those operating through demand

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Influences on Supply

• Wealth As savers become wealthier, more bonds
  are held S shifts outward
• Expected return on other assets The higher
  expected returns are elsewhere, the fewer bonds
  are held S shifts inward
• Risk The riskier bonds are, the fewer are held
  S shifts inward

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More Influences on Supply

• Liquidity The more liquid bonds are, the more
  are held S shifts outward
• Information costs The greater are the bonds
  information costs, the fewer are held S shifts
  inward
• Expected inflation rate To keep the real
  interest rate received constant, the nominal
  interest rate must rise one-for-one with the
  expected inflation rate S shifts upward
  one-for-one

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Summary for Supply
i
i
S
S
S
Exp Ret Elsewhere up
Risk, Info Cost up
X
Wealth, Liquidity up
Exp Inf up x
l
l
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Influences on Demand

• Expected pretax profitability of capital The
  higher it is, the more capital businesses wish to
  have and the more bonds they issue D shifts
  outward
• Business taxation The lower it is, the more
  capital businesses wish to have and the more
  bonds they issue D shifts outward
• Expected inflation rate To keep the real
  interest rate paid constant, the nominal interest
  rate must increase one-for-one with the expected
  inflation rate D shifts upward one-for-one

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Summary for Demand
i
i
Exp Inf up x
Exp Pretax Prof of K up
Bus Tax down
X
D
D
D
l
l
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1. Effects on i of Changes

• Wealth or liquidity rises or expected return on
  other assets falls
• S shifts outward
• D doesnt shift
• i decreases, l increases

i
S0
S1
D
l
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2. Effects on i of Changes

• Expected pretax profitability increases or
  business taxation decreases
• S doesnt shift
• D shifts outward
• i increases, l increases

i
S
D1
D0
b
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3. Effects of Changes on i

• Expected inflation rate increases by 5
• S shifts upward 5
• D shifts upward 5
• i increases 5
• r and l constant

i
i1 i0 5
S1
i1
S0
D1
i0
D0
l
l0
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Application Effect of Recession

• D shifts inward and downward because
• Expected profitability of K falls
• Expected inflation falls
• S shifts outward and downward because
• Expected inflation falls
• Flight to quality
• Result i falls

i
i1 i0 5
Sboom
iboom
Srecess
Dboom
irecess
Drecess
l
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International Capital Markets

• In internationally open capital markets
• Borrowers are free to borrow wherever they wish.
• savers are free to lend wherever they wish.
• Interest rates are equated across nations.

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Two-Country Model

• We can obtain some additional insight from the
  case in which the world consists of only two
  countries A and B
• A and B have financial markets of comparable size
• We compare two situations
• Their financial markets are completely isolated
  from each other
• Capital flows completely freely between them

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i
i
B
A
S
iA
D
S
v
u
y
z
i
x
w
D
iB
lA
lB
l
l

• With isolated financial markets, interest rates
  are iA and iB, lending and borrowing in A are lA,
  and lending and borrowing in B are lB
• With freely flowing capital, the interest rate is
  at the level i in both countries so that world
  lending world borrowing i.e., uw xz (See
  the next slide)

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i
i
B
A
S
iA
D
S
v
u
y
z
i
x
w
D
iB
lA
lB
l
l

• quantity demanded quantity supplied
• (lA vw) (lB xy) (lA uv) (lB yz)
• vw xy uv yz
• uv vw xy yz
• uw xz

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i
i
B
A
S
iA
D
S
v
u
y
z
i
x
w
D
iB
lA
lB
l
l

• savers in B lend yz more and are better off
• Borrowers in B borrow xy less and are worse off
• Borrowers in A borrow vw more and are better off
• Savers in A lend uv less and are worse off
• Lending of xz ( uw) flows from B to A
• Gainers gain more than losers lose national
  income is higher.

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Effects Demand Shift in One Country
i
i
A
B
S
D
u'w' x'y'
i1
S
u'
w'
x'
z'
i0
u
w
x
z
uw xz
D0
D1
l
l

• Effects on i are reduced
• Example above D shifts outward in A
• Effects smaller because B savers supply more
  loanable funds and B borrowers demand less.

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An Almost Small Country
Almost Small Country
Rest of World
i

• The smaller a country is relative to the world,
  the less its interest rate is affected by its own
  conditions.
• In the limit of a small country, its interest
  rate is independent of its own conditions.

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1. Small-Country Model

• The interest rate i is given by conditions in
  the rest of the world, independent of conditions
  in the small country.
• Real world examples Canada, Belgium, etc.

i
S
i
D
l
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2. Small-Country Model

• Shifts in D (yellow) or S (purple) do not affect
  i ( i). Instead, they affect how much capital
  flows out of (or into) the country.

i
S
i
D
S
D
l