Interest Rate Determinants

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Chapter 2

• Interest Rate Determinants

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The Role of Financial Intermediaries

• Unique supply determinants are a distinguishing
  characteristic of financial markets
• Loanable funds are generated by economic units
  that consume less than they earn
• Intermediaries are simply institutions which act
  as middlemen between ultimate savers and
  user-borrowers

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Primary and Secondary Financial Markets

• Primary mortgage markets are those in which
  mortgages originate
• Depository and nondepository institutions
• Secondary financial markets comprise arrangements
  for buying and selling existing financial
  instruments in organized trading markets such as
  the various stock exchanges
• Fannie Mae, Ginnie Mae, Freddie Mac, private
  investors

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Figure 2.1
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Supply, Demand, and Market-Clearing Interest Rates

• Analysis of supply and demand for loanable funds
  and their role in determining market rates of
  interest represent a straightforward application
  of basic economic concepts
• Interest represents the price of borrowing or the
  reward for lending, and the level of interest
  rates (price of funds) depends on the relative
  positions of suppliers (lenders) and demanders
  (borrowers) in the marketplace

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Figure 2.2
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Changes in Demand

• Demand for loans varies inversely with market
  interest rates. Underlying factors interact to
  determine the demand function
• Expected demand for the product being produced
• Cost of productive elements other than capital
• Changes in technology and innovation
• Shifting expectations concerning the future
  economic and political environment

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Figure 2.3
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Market-Induced Supply Changes

• Savings is primarily a function of the level of
  disposable income

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Government-Induced Supply Changes

• The Board of Governors of the Federal Reserve
  System (the Fed) exercises substantial
  discretionary control over the money supply
• Purchase and/or sale of government bonds via its
  open market operations
• Changing the percentages of certain types of
  deposits banks must keep on hand (reserve
  requirements)
• Varying the discount rate (the interest rate the
  Fed charges banks for short-term loans)

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Government-Induced Supply Changes (Cont.)

• Impact of government-induced money supply changes
  falls almost entirely on loanable funds
• Influence of the U.S. bond market on the Feds
  monetary policy decisions has become increasingly
  significant