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5
Chapter
The Determinants of Interest Rates:
Competing Ideas
Money and Capital Markets
Financial Institutions and Instruments in a Global Marketplace
Eighth Edition
Peter S. Rose
McGraw Hill / Irwin
Slides by Yee-Tien (Ted) Fu
5-2
 Learning Objectives 
 To understand the important roles and
functions that interest rates perform within the
economy and the financial system.
 To explore the most important ideas about the
determinants of interest rates and asset prices.
 To identify the key forces that economists
believe set market interest rates and asset
prices into motion.
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5-3
Introduction
 The acts of saving and lending, and borrowing
and investing, are significantly influenced by
and tied together by the interest rate.
 The interest rate is the price a borrower must
pay to secure scarce loanable funds from a
lender for an agreed-upon time period.
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Functions of the Interest Rate in the Economy
 The interest rate helps guarantee that current
savings will flow into investment to promote
economic growth.
 It rations the available supply of credit,
generally providing loanable funds to those
investment projects with the highest return.
 It brings the supply of money into balance with
the public’s demand for money.
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5-5
Functions of the Interest Rate in the Economy
 The interest rate serves as an important tool for
government policy through its influence on the
volume of savings and investment.
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Classical Theory of Interest Rates
 The classical theory argues that the rate of
interest is determined by two forces:

the supply of savings, derived mainly from
households, and
 the demand for investment capital, coming mainly
from the business sector.
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Classical Theory of Interest Rates
Household Savings
 Current household savings equal the difference
between current income and current
consumption expenditures.
 Individuals prefer current over future
consumption, and the payment of interest is a
reward for waiting.
 Higher interest rates encourage the substitution
of current saving for current consumption.
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5-8
The Classical Theory of Interest Rates
The Substitution Effect
Relating Savings and Interest Rates
Interest
Rate

r2
r1

S1
McGraw Hill / Irwin
S2
Current
Saving
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5-9
The Classical Theory of Interest Rates
Business and Government Savings
 Most businesses hold savings balances in the
form of retained earnings, the amount of
which is determined principally by business
profits, and to a lesser extent, by interest rates.
 Income flows in the economy and the pacing
of government spending programs are the
dominant factors affecting government savings
(budget surplus).
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 10
The Classical Theory of Interest Rates
The Demand for Investment Funds
 Gross business investment equals the sum of
replacement investment and net investment.
 The investment decision-making process
typically involves the calculation of a project’s
expected internal rate of return, and the
comparison of that expected return with the
anticipated returns of alternative projects, as
well as with market interest rates.
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 11
The Classical Theory of Interest Rates
The Cost of Capital and the Investment Decision
Expected
Internal
Rates of
Return on
Alternative
Investment
Projects
A – acceptable
15%
B – acceptable
12%
C – indifferent
10%
D
E
unprofitable 8%
unprofitable 7%
Cost of
Capital
Funds
= 10%
Dollar Cost of Investment Projects
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 12
The Classical Theory of Interest Rates
The Investment Demand Schedule
In the Classical Theory of Interest Rates
Interest
Rate
r2


r1
I2
McGraw Hill / Irwin
I1
Investment
Spending
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5 - 13
The Classical Theory of Interest Rates
The Equilibrium Rate of Interest
In the Classical Theory of Interest Rates
Interest
Rate Investment Savings
rE

QE
McGraw Hill / Irwin
Savings &
Investment
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 14
The Classical Theory of Interest Rates
Limitations
 Factors other than savings and investment that
affect interest rates are ignored. For example,
many financial institutions can “create” money
today by making loans to the public.
 Today, economists recognize that income is
more important than interest rates in
determining the volume of savings.
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The Classical Theory of Interest Rates
Limitations … continued
 In addition to the business sector, both
consumers and governments are also important
borrowers today.
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 16
The Liquidity Preference (Cash Balances)
Theory of Interest Rates
 The liquidity preference (or cash balances)
theory of interest rates is a short-term theory
that was developed for explaining near-term
changes in interest rates, and hence, is more
relevant for policymakers.
 According to the theory, the rate of interest is
the payment to money (cash balances) holders
for the use of their scarce resource (liquidity),
by those who demand liquidity (i.e. money or
cash balances).
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 17
The Liquidity Preference (Cash Balances)
Theory of Interest Rates
 The demand for liquidity stems from:

the transactions motive - the purchase of goods
and services
 the precautionary motive - to cope with future
emergencies and extraordinary expenses
 the speculative motive - a rise in interest rates
results in lower bond prices

and  depend on the level of national income,
business sales, and prices (but not interest rates).
So, demand due to  and  is fixed in the short term.
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 18
The Liquidity Preference (Cash Balances)
Theory of Interest Rates
The Total Demand for Money or Cash Balances
in the Economy
Interest
Rate
Total Demand
= +  + 

r
+

K
McGraw Hill / Irwin
Q
 : transactions
demand
 : precautionary
demand
 : speculative
demand
Quantity of
Money / Cash
Balances
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 19
The Liquidity Preference (Cash Balances)
Theory of Interest Rates
 In modern economies, the money supply is
controlled, or at least closely regulated, by the
government.
 The supply of money (cash balances) is often
assumed to be inelastic with respect to interest
rates, since government decisions concerning
the size of the money supply should
presumably be guided by public welfare.
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 20
The Liquidity Preference (Cash Balances)
Theory of Interest Rates
The Equilibrium Interest Rate
In the Liquidity Preference Theory
Interest
Rate
rE
Money
Supply

QE
McGraw Hill / Irwin
Total
Demand
Quantity of
Money / Cash
Balances
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5 - 21
The Liquidity Preference (Cash Balances)
Theory of Interest Rates
Limitations
 The liquidity preference theory is a short-term
approach. In the longer term, the assumption
that income remains stable does not hold.
 Only the supply and demand for money is
considered. A more comprehensive view that
considers the supply and demand for credit by
all actors in the financial system - businesses,
households, and governments - is needed.
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5 - 22
The Loanable Funds Theory of Interest
 The popular loanable funds theory argues that
the risk-free interest rate is determined by the
interplay of two forces:

the demand for credit (loanable funds) by
domestic businesses, consumers, and
governments, as well as foreign borrowers
 the supply of loanable funds from domestic
savings, dishoarding of money balances, money
creation by the banking system, as well as foreign
lending
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 23
The Loanable Funds Theory of Interest
The Demand for Loanable Funds
 Consumer (household) demand is relatively
inelastic with respect to the rate of interest.
 Domestic business demand increases as the
rate of interest falls.
 Government demand does not depend
significantly upon the level of interest rates.
 Foreign demand is sensitive to the spread
between domestic and foreign interest rates.
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 24
The Loanable Funds Theory of Interest
Total Demand for Loanable Funds (Credit)
Interest
Rate
Total Demand = Dconsumer +
Dbusiness +
Dgovernment +
Dforeign
Amount of
Loanable Funds
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5 - 25
The Loanable Funds Theory of Interest
The Supply of Loanable Funds
 Domestic Savings. The net effect of income,
substitution, and wealth effects is a relatively
interest-inelastic supply of savings curve.
 Dishoarding of Money Balances. When
individuals and businesses dispose of their
excess cash holdings, the supply of loanable
funds available to others is increased
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5 - 26
The Loanable Funds Theory of Interest
The Supply of Loanable Funds … continued
 Creation of Credit by the Domestic Banking
System. Commercial banks and nonbank thrift
institutions offering payments accounts can
create credit by lending and investing their
excess reserves.
 Foreign lending is sensitive to the spread
between domestic and foreign interest rates.
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 27
The Loanable Funds Theory of Interest
Total Supply of Loanable Funds (Credit)
Interest
Rate
Total Supply
= domestic savings +
newly created money +
foreign lending –
hoarding demand
Amount of
Loanable Funds
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 28
The Loanable Funds Theory of Interest
The Equilibrium Interest Rate
Interest
Rate
rE
Supply

Demand
QE
McGraw Hill / Irwin
Amount of
Loanable Funds
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 29
The Loanable Funds Theory of Interest
 At equilibrium:

Planned savings = planned investment across the
whole economic system
 Money supply = money demand
 Supply of loanable funds = demand for loanable
funds
 Net foreign demand for loanable funds = net
exports
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 30
The Loanable Funds Theory of Interest
 Interest
rates will be stable only when the
economy, money market, loanable funds
market, and foreign currency markets are
simultaneously in equilibrium.
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 31
The Rational Expectations Theory of Interest
 The rational expectations theory builds on a
growing body of research evidence that the
money and capital markets are highly efficient
in digesting new information that affects
interest rates and security prices.
McGraw Hill / Irwin
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5 - 32
The Rational Expectations Theory of Interest
 The public forms rational and unbiased
expectations about the future demand and
supply of credit, and hence interest rates.
Interest
Rate
rE
Expected Supply

Expected Demand
QE
McGraw Hill / Irwin
Amount of
Loanable Funds
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 33
The Rational Expectations Theory of Interest
 If the money and capital markets are highly
efficient, then interest rates will always be very
near their equilibrium levels, and the optimal
forecast of next period’s interest rate is the
current interest rate.
 Interest rates will change only if entirely new
and unexpected information appears, and the
direction of change depends on the public’s
current set of expectations.
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 34
The Rational Expectations Theory of Interest
Limitations
 At the moment, we do not know very much
about how the public forms its expectations.
 The cost of gathering and analyzing
information relevant to the pricing of assets is
not always negligible, as assumed.
 Not all interest rates and security prices appear
to display the kind of behavior implied by the
rational expectations theory.
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 35
Money and Capital Markets in Cyberspace
 Many websites explore topics related to
interest rates. See, for example,

http://www.lombard-st.co.uk/

http://www.rate.net/

http://www.globalfindata.com/

http://money.cnn.com/
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 36
Chapter Review
 Introduction
 Functions of the Interest Rate in the Economy
 The Classical Theory of Interest Rates
Savings by Households, Business Firms and
Governments
 The Demand for Investment Funds
 The Equilibrium Interest Rate
 Limitations of the Classical Theory

McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 37
Chapter Review
 The Liquidity Preference or Cash Balances
Theory of Interest Rates
The Demand for Liquidity
 The Supply of Money (Cash Balances)
 The Equilibrium Interest Rate
 Limitations of the Liquidity Preference Theory

McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
5 - 38
Chapter Review
 The Loanable Funds Theory of Interest
The Demand for Loanable Funds
 The Supply of Loanable Funds
 The Equilibrium Interest Rate

 The Rational Expectations Theory of Interest
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.