Download CHAPTER TWO - Bentley University

DETERMINATION OF
INTEREST RATES
OBJECTIVES
1. To explain the Loanable Funds Theory
of interest rate determination
2. To identify the major factors affecting
the level of interest rates
3. To discuss the Fed’s monetary policy
tools
LOANABLE FUNDS
THEORY (LFT)

One of several theories of how the general level of
interest rates is determined

Interest rates determined by demand and supply for
loanable funds

However, as economic and other factors also influence
the demand and/or supply level they do impact on
interest rate
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DEMAND FOR LOANABLE
FUNDS






Households borrow for consumption (auto, mortgage, etc)
Businesses borrow to invest in plant and machinery
Governments borrow to cover budget deficits (arising
from expenditure exceeding revenues)
Foreign governments and businesses borrow in larger,
efficient U.S. financial markets, with lower rates
Government demand is interest inelastic, but all other
demand curves (on aggregate) slope downwards
Are all components of aggregate consumer spending
sensitive to interest rates?
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SUPPLY OF LOANABLE
FUNDS

Households are the major suppliers of funds

Households save from their income to increase future consumption
Rate of savings depends on their preferences for current vs. future
consumption, level of income, amount of wealth, and interest rates


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
But is it always the case that higher interest rates lead to
increased savings; i.e., does the supply curve have to
slope upward?
Substitution Effect vs. Income Effect
Businesses also invest (loan) funds temporarily, but do
interest rates influence the amount they save (retain)?
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SUPPLY OF LOANABLE
FUNDS


Government (municipalities, agencies) may also supply
funds temporarily
Federal Reserve’s monetary policy may increase money
supply - to lower interest rates and improve economy

Does increasing money supply always cause lower rates?

Foreign governments and households are net suppliers to
the U.S. - induced by interest rate differentials
Overseas inflows are also influenced by expected changes
in the exchange rate

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GENERAL EQUILIBRIUM
INTEREST RATE

Equilibrium interest rate is that rate at which the
quantity of aggregate loanable funds demanded is
equal to the aggregate supply of loanable funds

Means of explaining how economic factors affect
interest rate levels. How?

Surplus and shortage conditions impact on the
equilibrium interest rate
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INTEREST RATE
DETERMINATION
Interest
Rates
Demand for Loanable Funds
Supply of Loanable Funds
Quantity of Loanable Funds
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OTHER FACTORS
AFFECTING RATES
Changes in demand/supply of loanable funds due to
level of economic activity
1. Increase in demand by businesses due to optimistic
economic projections leads to increased interest rates if
there is no offsetting increase in supply
2. Economic slowdown leads to a decrease in demand for
loanable funds by firms
=> Supply may increase as workers save more in
expectation of worse times. Therefore, interest rates
are likely to fall

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FACTORS AFFECTING
INTEREST RATES
Inflation and the FISHER Effect
1. Lenders want to be compensated for loss of purchasing
power (inflation)
2. Expected increase in inflation leads to higher interest
rates next period
3. Nominal interest rates  real interest rate + expected
rate of inflation

in  ir  E(I)
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FACTORS AFFECTING
INTEREST RATES
Increased Federal Government Deficit
1. Deficit arises when government expenditure exceeds its
revenues
2. Government increases its demand for loanable funds;
Demand curve shifts to the right  interest rates rise
3. Supply of funds increases but less than increase in
government demand
4. This leads to “crowding out” of other borrowers
Deficit spending may improve economy and increase
savings, thus partially offsetting interest rate increase

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FACTORS AFFECTING
INTEREST RATES

Crowding-Out Effect
Interest Rates
Increase in government borrowing
Supply
i2
i1 i 1
Demand2
Demand1
Loanable funds
Crowding out
Increase in funds
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FACTORS AFFECTING
INTEREST RATES
Influence of Foreign Interest Rates
1. Few remaining segmenting barriers between major
money markets
2. Higher (lower) rates in the home market attract
(discourage) foreign loanable funds, hence, decreasing
(increasing) interest rates in the home market
3. Exposure to currency risk impedes the interest rate
equalization across countries
Given current economic conditions, characterize the
(net) flow of funds between the U.S.A. and Japan

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FACTORS AFFECTING
INTEREST RATES
 Federal
Reserve Monetary Policy
1. Open market operations affect bank reserves which
impacts on Fed funds rates, rates on loanable funds and
rates paid on new deposits by financial institutions
E.g., Low rates on new deposits force funds to alternative investments. The
latter experience reduced interest rates as a result of the increase in supply.
2. Adjusting the discount rate may influence the Fed funds
and other market-determined rates. The latter also
impact on the discount rate
3. Adjusting the reserve requirement ratio impacts on the
supply of loanable funds, hence, general interest rates
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