Transcript Loanable funds theory

Chapter 2
Determination of Interest Rates
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
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Chapter Outline
Loanable funds theory
 Economic forces that affect interest rates
 Forecasting interest rates

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Loanable Funds Theory

Loanable funds theory suggests that the
market interest rate is determined by the factors
that affect the supply of 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
3
Loanable Funds Theory (cont’d)

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
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Loanable Funds Theory (cont’d)

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):
n

CFt
NPV  INV 
t
(
1

k
)
t 1


Projects with a positive NPV are accepted
There is an inverse relationship between interest rates and
business demand for loanable funds
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Loanable Funds Theory (cont’d)

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
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Loanable Funds Theory (cont’d)

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
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Loanable Funds Theory (cont’d)

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 (cont’d)
Dh
Household Demand
Db
Business Demand
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Loanable Funds Theory (cont’d)
Dg
Federal Government Demand
Dm
Municipal Government Demand
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Loanable Funds Theory (cont’d)
Df
Foreign Demand
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Loanable Funds Theory (cont’d)
DA
Aggregate Demand
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Loanable Funds Theory (cont’d)

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
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Loanable Funds Theory (cont’d)

Supply of loanable funds (cont’d)
 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
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Loanable Funds Theory (cont’d)
SA
Aggregate Supply
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Loanable Funds Theory (cont’d)

Equilibrium interest rate - algebraic
 The
aggregate demand can be written as
DA  Dh  Db  Dg  Dm  Df
 The
aggregate supply can be written as
SA  Sh  Sb  Sg  Sm  Sf
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Loanable Funds Theory (cont’d)
SA
i
DA
Equilibrium Interest Rate - Graphic
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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
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Loanable Funds Theory (cont’d)
SA
i2
i
DA2
DA
Impact of Economic Expansion
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Economic Forces That Affect
Interest Rates (cont’d)

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
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Loanable Funds Theory (cont’d)
SA2 S
A
i2
i
DA2
DA
Impact of Expected Increase in Inflation
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Economic Forces That Affect
Interest Rates (cont’d)

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
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Economic Forces That Affect
Interest Rates (cont’d)

Fisher effect (cont’d)
 Fisher
effect equation:
i  E (INF )  i R
 The
difference between the nominal interest rate
and the expected inflation rate is the real
interest rate:
i R  i  E (INF )
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Economic Forces That Affect
Interest Rates (cont’d)

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 decreases
 During 2001, the Fed increased the growth of
the money supply several times
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Economic Forces That Affect
Interest Rates (cont’d)

Money supply (cont’d)
 September
11
Firms cut back on expansion plans
 Households cut back on borrowing plans
 The demand of loanable funds declined

 The
weak economy in 2001–2002
Reduced demand for loanable funds
 The Fed increased the money supply growth
 Interest rates reached very low levels

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Economic Forces That Affect
Interest Rates (cont’d)

Budget deficit

A high deficit means a high demand for loanable funds by the
government



The government may be willing to pay whatever is necessary to
borrow funds, but the private sector may not


Shifts the demand schedule outward (to the right)
Interest rates increase
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
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Economic Forces That Affect
Interest Rates (cont’d)

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
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Economic Forces That Affect
Interest Rates (cont’d)

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
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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
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Forecasting Interest Rates (cont’d)

To forecast future interest rates, the net
demand for funds (ND) should be forecast:
ND  DA  SA

 S

S 
 Dh  Db  Dg  Dm  Df
h
 Sb  Sg  Sm
f
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Forecasting Interest Rates (cont’d)
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

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