01 fm&i chap 2

Loanable Funds Theory⚫ Household Sector--Usually a net supplier of loanable funds ⚫ Business Sector—Usually a net demander in growth periods ⚫ Government Sectors: Borrow for capital p

Chapter 2: Determination of

Interest Rates

■apply the loanable funds theory to explain why interest rates change

■ identify the most relevant factors that

affect interest rate movements

■ explain how to forecast interest rates

Loanable Funds Theory

1 The Loanable Funds Theory suggests that

the market interest rate is determined by the

factors that control supply of and demand for

loanable funds

2 Can be used to explain:

 Movements in the general level of interest

rates in a particular country

 Why interest rates among debt securities of a

given country vary

Loanable Funds Theory

⚫ Demand = borrowers, issuers of securities, deficit spending unit

⚫ Supply = lenders, financial investors,

buyers of securities, surplus spending unit

⚫ Assume economy divided into sectors

⚫ Slope of demand/supply curves related to elasticity or sensitivity of interest rates

Loanable Funds Theory

⚫ Household Sector Usually a net supplier

of loanable funds

⚫ Business Sector—Usually a net demander

in growth periods

⚫ Government Sectors: Borrow for capital

projects and deficit spending

⚫ Foreign Sectors—Net supplier or

demander

Demand for Loanable Funds

1 Household demand for loanable funds

a Households demand loanable funds to finance housing expenditures as well

as the purchase of automobiles and household items.

b Inverse relationship between the

interest rate and the quantity of loanable funds demanded

Relationship between Interest Rates and

Household Demand (Dh) for Loanable Funds at a Given Point in Time

Demand for Loanable Funds

2 Business demand for loanable funds

a Depends on number of business projects to be

implemented More demand at lower interest rates.

project

on return of

rate required

period

in flow cash

investment initial

project of

lue present va net

) 1

INV NPV

k

CF INV

Demand for Loanable Funds

⚫ Projects with a positive NPV are accepted because the present value of their benefits outweighs their costs

⚫ If interest rates decrease, more projects will have a positive NPV

 Businesses will need a greater amount of financing

 Businesses will demand more loanable funds

Relationship between Interest Rates and Business

Demand (Db) for Loanable Funds at a Given Point in Time

Demand for Loanable Funds

3 Government demand for loanable funds

a Governments demand loanable funds when planned expenditures are not

covered by incoming revenues.

b Government demand is said to be

interest inelastic : insensitive to interest rates Expenditures and tax policies are independent of the level of interest rates.

Impact of Increased Government Deficit on the Government Demand for Loanable Funds

Demand for Loanable Funds

4 Foreign demand for loanable funds

a A foreign country’s demand for domestic funds depends on the interest rate

differential between the two.

b The quantity of domestic loanable funds demanded by foreign investors will be

inversely related to domestic interest

rates.

Impact of Increased Foreign Interest Rates on the Foreign Demand for U.S Loanable Funds

Demand for Loanable Funds

Aggregate demand for loanable funds

 The sum of the quantities demanded by the

separate sectors at any given interest rate

D A = D h + D b + D g + D m + D f

D h = household demand for loanable funds

D b = business demand for loanable funds

D g = federal government demand for loanable funds

D m = municipal government demand for loanable funds

D f = foreign demand for loanable funds

Determination of the Aggregate

Demand Curve for Loanable Funds

Supply of Loanable Funds

1 Households are largest supplier, but

businesses and governments may invest (loan) funds temporarily

 More supply at higher interest rates

 Supply by buying securities

2 Effects of the central bank (US: Fed,

Vietnam: SBV) - By affecting the supply of

loanable funds, the central bank’s monetary

policy affects interest rates

3 Variables other than interest rate changes

causes a shift in the supply curve

Supply of Loanable Funds

Aggregate supply of funds –Is the combination of all sector supply schedules along with the supply of funds provided by the central bank’s monetary policy

S A = S h + S b + S g + S m + S f

S h = household supply for loanable funds

S b = business supply for loanable funds

S g = federal government supply for loanable funds

S m = municipal government supply for loanable funds

S f = foreign supply for loanable funds

Aggregate Supply Curve for Loanable Funds

Equilibrium Interest Rate

⚫ Interest rate level where quantity of aggregate

loanable funds demanded = supply

⚫ When a disequilibrium situation exists, market

forces should cause an adjustment in interest rates until equilibrium is achieved

⚫ Surplus and shortage conditions

Surplus- Quantity demanded < quantity

supplied followed by market interest rate

decreases

Shortage- followed by market interest rate

increases

Interest Rate Changes

⚫ + Directly related to level of economic

activity or growth rate of economic activity

⚫ + Directly related to expected inflation

⚫ – Inversely related to rates of money

supply changes

Economic Forces That Affect Interest Rates: Economic Growth

1 Impact of Economic Growth

 Expected impact is an outward shift in the demand schedule without obvious shift in supply

 New technological applications with

positive NPVs

 Result is an increase in the equilibrium interest rate

Impact of Increased Expansion by Firms

Impact of an Economic Slowdown

Economic Forces That Affect Interest Rates: Inflation

2 Impact of inflation on interest rates

a Lenders want to be compensated for

expected loss of purchasing power

(inflation) when they lend

b Fisher effect: i = E(INF) + iR

where i = nominal or quoted rate of

interest

E(INF) = expected inflation rate

iR = real interest rate

Economic Forces That Affect Interest Rates: Inflation

⚫ If inflation is expected to increase: Puts upward pressure on interest rates by shifting supply of

funds inward and demand for funds outward

Households may reduce their savings to make purchases before prices rise

Supply shifts to the left, raising the equilibrium rate

Also, households and businesses may borrow more to purchase goods before prices increase

Demand shifts outward, raising the equilibrium rate

Impact of an increase in expected inflation

Economic Forces That Affect Interest Rates: Money Supply

3 Impact of money supply

⚫ Money Supply

 When the central bank increases the

money supply, it increases supply of

loanable funds

 Places downward pressure on interest rates

Economic Forces That Affect Interest Rates: Budget Deficit

4 Impact of budget deficit

 Increase in deficit increases the quantity

of loanable funds demanded

 Demand schedule shifts outward,

raising rates

 Government is willing to pay whatever

is necessary to borrow funds, “crowding out” the private sector

Economic Forces That Affect Interest Rates: Foreign Flows

4 Impact of foreign flows

In recent years there has been massive flows

between countries

Driven by large institutional investors seeking

high returns

They invest where interest rates are high and

currencies are not expected to weaken

These flows affect the supply of funds available

in each country

Investors seek the highest real after-tax,

exchange rate adjusted rate of return around the world

Forecasting Interest Rates

⚫ Attempts to forecast demand/supply shifts

⚫ Forecast economic sector activity and

impact upon demand/supply of loanable funds

⚫ Forecast incremental effects on interest rates

⚫ Forecasting interest rates has been

difficult

Forecasting Interest Rates

1 Future Demand for Loanable Funds depends on future

a Foreign demand for domestic funds

b Household demand for funds

c Business demand for funds

d Government demand for funds

2 Future Supply of Loanable Funds depends on:

a Future supply by households and others

b Future foreign supply of loanable funds in the country

▪ The loanable funds framework shows how the equilibrium interest rate depends on

the aggregate supply of available funds

and the aggregate demand for funds As conditions cause the aggregate supply or demand schedules to change, interest

rates gravitate toward a new equilibrium

▪ Given that the equilibrium interest rate is determined by supply and demand

conditions, changes in the interest rate

can be forecasted by forecasting changes

in the supply of and the demand for

loanable funds Thus, the factors that

influence the supply of funds and the

demand for funds must be forecast in

order to forecast interest rates.

⚫ The relevant factors that affect interest rate

movements include changes in economic growth, inflation, the budget deficit, foreign interest rates, and the money supply These factors can have a strong impact on the aggregate supply of funds

and/or the aggregate demand for funds and can thereby affect the equilibrium interest rate In

particular, economic growth has a strong influence

on the demand for loanable funds, and changes in the money supply have a strong impact on the

supply of loanable funds