Download Figure 1.1 Loanable funds approach

Chapter 1
Determinants of
Interest Rates
1-1
Loanable Funds Approach
Interest rates
Demand
Supply
i
Demand = Supply
Loanable
funds
1-2
The Demand for Funds
 Business investment – the sum total of
investment opportunities for all
businesses in the economy. This is a
list of investments from those with the
highest returns to the lowest returns.
 Consumer borrowing – sum total of
consumer borrowing in the economy.
 Government deficits.
1-3
Capital Budgeting
ROR
.20
Accept
.15
.10
.05
Cost of funds
Reject
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Project #1 Project #3
Project #2 Project #4
1-4
Supply of Funds
 Individual savings. Most economists
assume that as the interest rate
increases consumers save larger
dollar amounts. Thus, the supply
curve is upward sloping.
 Business savings. Retained earnings
for all businesses.
 Increases in the money supply.
1-5
An Increase in the Money
Supply
Interest rates
Demand
i1
i2
Supply1
Supply2
Increase in
money
supply
Loanable
funds
1-6
Increased Government
Borrowing
Interest rates
Demand1
Demand2
Increase in
government
borrowing
Supply
i2
i1
Loanable
funds
1-7
Circular Flow for the Entire
Economy
Income
Production
Total Income = Total Production
Income Per Capita = Production Per Capita
1-8
The Federal Reserve
 The Federal Reserve is the central
bank of the United States. It has two
parts.
 12 regional Federal Reserve Banks.
The country is divided into 12 Federal
Reserve regions, each of which has a
Federal Reserve bank with branches in
different parts of the district.
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Board of Governors
 There is a board of seven governors of
the Federal Reserve.
 They are located in Washington D.C.
 Each governor is appointed to fill a 14
year term, which are staggered so that
a new term becomes available every
two years.
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 Each of the seven governors is
appointed by the President of the
United States with the consent of the
United States Senate.
 One of the governors is designated as
chairman of the Federal Reserve
Board and serves a four-year term as
chairman, which begins in the fourth
year of a Presidential term.
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 The chairman has special influence for
several reasons.
He has the last word at meetings.
He can act for the Federal Reserve in
emergencies.
He is the spokesperson for the Federal
Reserve before the Congress and the
public.
He is chosen because of his strong
personality.
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The Federal Open Market
Committee (FOMC)
 Monetary policy is set by the Federal
Open Market Committee, which has
eight regularly scheduled meetings
during the course of the year,
approximately six weeks apart. Each
meeting is attended by the 7
governors and the 12 presidents of the
district Federal Reserve Banks. The
meeting typically lasts 2 days.
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 The result of these meetings is a
policy directive on monetary policy.
The directive sets bounds sets a target
for the federal funds rate, and also
may set bounds on the growth rate of
the money supply.
 Voting Rules: 7 governors, president
of NY Fed and 4 other presidents on a
rotating basis vote.
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 In recent years, the directive has
concentrated on the federal funds rate.
 The federal funds rate is the rate at
which banks borrow and lend funds to
each other. These are funds that are
on deposit at the Federal Reserve to
meet reserve requirements. Banks
with excess funds are lenders. Banks
short of funds are borrowers.
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 When the Federal Reserve wants to
tighten monetary conditions, it increases
the target federal funds rate (although
the change is carried out by open market
operations, discussed below).
 All short-term interest rates tend to move
together.
1-16
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Fractional Reserve Banking System
and Federal Funds
Average Deposits
Lag
Average Reserves
Time
1-17
Fed Funds vs. Fed Discount Rate
Rates of
Interest
Fed Discount Rate
Fed Funds
Time1-18
Independence of the
Federal Reserve
 The Federal Reserve is relatively
independent from the rest of the
government for several reasons.
1-19
Independence of the
Central Bank and Inflation
Inflation
Rate



Italy
UK
US
Independent
Not Independent
1-20
Goals of the Federal
Reserve
 Low inflation. Why is inflation bad?
a. Some people lose from inflation
because they are on fixed dollar
incomes or hold money.
b. In the long run, high inflation tends
to reduce economic growth and
income of the population.
c. High inflation fosters political
instability.
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 Full employment. The full employment
act and equity are the main reasons
for this.
 Economic growth. Since output for
the economy equals income for the
economy, increasing output
(economic growth) increases income.
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Tools of the Federal
Reserve
 Open market operations. Buying
(selling) bonds increases (reduces) the
money supply and lowers (increases)
interest rates.
 Changing reserve requirements.
 Discount window.
a.Temporary loans.
b.Seasonal loans.
c.Distress loans.
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Other Functions of the
Federal Reserve
 Collect checks.
 Fed wire.
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Inflation and Interest Rates
1-25
Irving Fisher’s Theory of
Inflation and Interest Rates
 Assumptions.
 Fisher examines the world from the
viewpoint of lenders only.
 One period horizon.
 No taxes.
 Complete certainty.
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Definitions
 The letter “r” is the inflation free
interest rate.
 The letter “p” is inflation rate.
 The letter “i” is the nominal or
observed interest rate.
 Then Irving Fisher’s theory implies the
following.
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i  r  p  rp.
Inflation

  Inflation  Pr oduct .
No min al 
 free 
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i = r + p + rp
i = 0.05 + 0.10 + (0.05)(0.10) = 0.155.
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Now
0
1
Time
-$1
+1
Principal
+r = 0.05
Foregone consumption
+p = 0.10
Depreciation in principal
+rp = 0.005
Depreciation in foregone
consumption
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The Case of Uncertainty
i  r  E(p)  h
Inflation Expected
Risk

.
i   Free  

Premium




Inflation




 Rate 
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i = 0.05 + 0.10 + 0.04 = 0.19 = 19%.
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Relationship between the Nominal
Interest Rate and Recent Inflation
Regression: [Nominal] = a + b[Recent infl.].
Nominal Interest
Rate






a













b = slope

b = 1?
0 < b < 1?
b > 1?
Recent Inflation
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