Determination of Interest Rates

1
Determination of Interest Rates

• Chapter 2

2
Outline

• Interest Rate Fundamentals
• Loanable funds theory
• Economic forces that affect interest rates
• Forecasting interest rates

3
Interest Rate Fundamentals

• Nominal interest rates - the interest rate
  actually observed in financial markets
• directly affect the value (price) of most
  securities traded in the market
• affect the relationship between spot and forward
  FX rates

4
Time Value of Money and Interest Rates

• Assumes the basic notion that a dollar received
  today is worth more than a dollar received at
  some future date
• Compound interest
• interest earned on an investment is reinvested
• Simple interest
• interest earned on an investment is not reinvested

5
Calculation of Simple Interest

• Value Principal Interest (year 1)
  Interest (year 2)
• Example
• 1,000 to invest for a period of two years at 12
  percent
• Value 1,000 1,000(.12) 1,000(.12)
• 1,000 1,000(.12)(2)
• 1,240

6
Value of Compound Interest

• Value Principal Interest Compounded
  interest
• Value 1,000 1,000(.12) 1,000(.12)
  1,000(.12)(.12)
• 1,0001 2(.12) (.12)2
• 1,000(1.12)2
• 1,254.40

7
Loanable Funds Theory

• Loanable funds theory
• 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
• 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

8
Loanable Funds Theory (contd)

• 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

9
Loanable Funds Theory (contd)

• 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)
• Projects with a positive NPV are accepted
• There is an inverse relationship between interest
  rates and business demand for loanable funds

10
Loanable Funds Theory (contd)

• Government demand for loanable funds
• Governments demand funds when planned
  expenditures are not covered by incoming revenues
• Municipalities issue municipal bonds
• The federal government issues Treasury securities
  and federal agency securities
• Government demand for loanable funds is
  interest-inelastic

11
Loanable Funds Theory (contd)

• Foreign Demand for loanable funds
• Foreign demand for U.S. funds is influenced by
  the interest rate differential between countries
• The quantity of U.S. loanable funds demanded by
  foreign governments or firms is inversely related
  to U.S. interest rates
• The foreign demand schedule will shift in
  response to economic conditions

12
Loanable Funds Theory (contd)

• 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

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Loanable Funds Theory (contd)
DA
Aggregate Demand
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Loanable Funds Theory (contd)

• Supply of loanable funds
• Funds are provided to financial markets by
• Households (net suppliers of funds)
• Government units and businesses (net borrowers of
  funds)
• Suppliers of loanable funds supply more funds at
  higher interest rates

15
Loanable Funds Theory (contd)

• Supply of loanable funds (contd)
• Foreign households, governments, and corporations
  supply funds by purchasing Treasury securities
• Foreign households have a high savings rate
• The supply is influenced by monetary policy
  implemented by the Federal Reserve System
• The Fed controls the amount of reserves held by
  depository institutions
• The supply curve can shift in response to
  economic conditions
• Households would save more funds during a strong
  economy

16
Loanable Funds Theory (contd)
SA
Aggregate Supply
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Loanable Funds Theory (contd)

• Equilibrium interest rate - algebraic
• The aggregate demand can be written as
• The aggregate supply can be written as

18
Loanable Funds Theory (contd)
SA
i
DA
Equilibrium Interest Rate - Graphic
19
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

20
Loanable Funds Theory (contd)
SA
i2
i
DA2
DA
Impact of Economic Expansion
21
Economic Forces That Affect Interest Rates
(contd)

• Inflation
• 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 purchase
  products before prices rise

22
Loanable Funds Theory (contd)
SA2
SA
i2
i
DA2
DA
Impact of Expected Increase in Inflation
23
Economic Forces That Affect Interest Rates
(contd)

• 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

24
Fisher Effect

• Approximate Relationship
• Exact relationship (when reported rates are
  compounded annually)
• Where r is the real interest rate
• R is the nominal interest rate
• i is the inflation rate

25
Fisher Effect

• Fisher equation R r E(i)
• The basic intuition is that investors will
  require compensation for inflation in order to
  hold securities whose returns are in nominal
  terms. The expected real rate is thus the nominal
  rate minus expected inflation
• If real interest rates are relatively constant,
  then fluctuations in nominal rates will be due to
  changes in expected inflation

26
Fisher Effect

• Example R 9, i 6
• Fisher effect Approximation
• r R - i
• 9 - 6 3
• Fisher effect Exact

27
Economic Forces That Affect Interest Rates
(contd)

• Money supply
• If the Fed increases the money supply, the supply
  of loanable funds increases
• If inflationary expectations are affected, the
  demand for loanable funds may also increase
• If the Fed reduces the money supply, the supply
  of loanable funds decrease

28
Economic Forces That Affect Interest Rates
(contd)

• Budget deficit
• A high deficit means a high demand for loanable
  funds by the government
• Shifts the 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

29
Economic Forces That Affect Interest Rates
(contd)

• Foreign flows of funds
• The interest rate for a currency is determined by
  the demand for and supply of that currency
• Impacted by the economic forces that affect the
  equilibrium interest rate in a given country,
  such as
• Economic growth
• Inflation
• Shifts in the flows of funds between countries
  cause adjustments in the supply of funds
  available in each country

30
Economic Forces That Affect Interest Rates
(contd)

• Explaining the variation in interest rates over
  time
• Late 1970s high interest rates as a result of
  strong economy and inflationary expectations
• 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

31
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

32
Forecasting Interest Rates (contd)

• To forecast future interest rates, the net demand
  for funds (ND) should be forecast

33
Forecasting Interest Rates (contd)

• 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