Determination of Interest Rates.ppt

1、2,Determination of Interest Rates,Chapter Objectives,Explain Loanable Funds Theory of Interest Rate Determination Identify Major Factors Affecting the Level of Interest Rates Explain How to Forecast Interest Rates,Relevance of Interest Rate Movements,Changes in interest rates impact the real economy

2、 Investment spending Interest sensitive consumer spending such as housing Interest rate changes affect the values of all securities Security prices vary inversely with interest rates Varying interest rates impact retirement funds and retirement income Interest rates changes impact the value of finan

3、cial institutions Managers of financial institutions closely monitor rates Interest rate risk is a major risk impacting financial institutions,1. Loanable Funds Theory of Interest Rate Determination,Theory of how the general level of interest rates are determined Explains how economic and other fact

4、ors influence interest rate changes Interest rates determined by demand and supply for loanable funds Used for explaining movements in the general level of interest rates for a particular country,Loanable Funds Theory, cont.,Demand = borrowers, issuers of securities, deficit spending unit Supply = l

5、enders, 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,Sectors of the Economy,Household Sector-Usually a net supplier of loanable funds Business SectorUsually a

6、net demander in growth periods Government Sectors StatesBorrow for capital projects FederalBorrow for capital projects and deficit spending Foreign SectorsNet supplier since early 1980s,1.1 Demand for Loanable Funds,Sum of sector demand (quantity) at varying levels of interest rates Sector cash rece

7、ipts in period less than outlays = borrower Quantity demanded inversely related to interest rates Variables other than interest rate changes cause shift in demand curve,Demand for Loanable Funds,Interest Rate,Quantity of Loanable Funds,1.1.1 Loanable Funds Theory,Households demand loanable funds to

8、finance housing, automobiles, household items These purchases result in installment debt. Installment debt increases with the level of income Various events (tax rates) can cause household borrowing preferences to change There is an inverse relationship between the interest rate and the quantity of

9、loanable funds demanded,Household Demand for Loanable Funds,1.1.2 Loanable Funds Theory,Businesses demand loanable funds to invest in long-term and short-term assets Quantity of funds demanded depends on how many projects to be implemented and supports ongoing operations (account receivable and inve

10、ntory) Businesses choose projects by calculating the projects Net Present Value Select all projects with +NPVs,Business Demand for Loanable Funds,Loanable Funds Theory,Net Present Value is calculated as follows:,Business Demand for Loanable Funds,Loanable Funds Theory,Projects with a positive NPV ar

11、e 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,Business Demand for Loanable Funds,Loanable Funds Theory,There

12、 is an inverse relationship between interest rates and the quantity of loanable funds demanded The curve can shift in response to events that affect business borrowing preferences Example: Economic conditions become more favorable Expected cash flows will increase more positive NPV projects increase

13、d demand for loanable funds,Business Demand for Loanable Funds,1.1.3 Loanable Funds Theory,When planned expenditures exceed revenues from taxes, the government demands loanable funds Municipal (state and local) governments issue municipal bonds Federal government and its agencies issue Treasury secu

14、rities and federal agency securities.,Government Demand for Loanable Funds,Loanable Funds Theory,Federal government expenditure and tax policies are independent of interest rates Government demand for funds is interest-inelastic,D,Interest Rate,Quantity of Loanable Funds,Government Demand for Loanab

15、le Funds,1.1.4 Loanable Funds Theory,A foreign countrys demand for U.S. funds is influenced by the differential between its interest rates and U.S. rates The quantity of U.S. loanable funds demanded by foreign investors will be inversely related to U.S. interest rates,Foreign Demand for Loanable Fun

16、ds,1.1.5 Loanable Funds Theory,The aggregate demand for loanable funds is the sum of the quantities demanded by the separate sectors The aggregate demand for loanable funds is inversely related to interest rates,Aggregate Demand for Loanable Funds,1.2 Sector Supply of Loanable Funds,Households are m

17、ajor suppliers of loanable funds Businesses and governments may invest (loan) funds temporarily Foreign sector a net supplier of funds in last twenty years (high savings rates) Federal Reserves monetary policy impacts supply of loanable funds Less elastic to interest rates-steep slope,Supply of Loan

18、able Funds,Sum of sector supply (quantity) at varying levels of interest rates Sector cash receipts in period greater than outlayslender Quantity supplied directly related to interest rates Variables other than interest rate changes causes a shift in the supply curve,Interest Rate,Quantity of Loanab

19、le Funds,1.3 Loanable Funds Theory-algebraic perspective,Equilibrium Interest Rate Aggregate Demand DA = Dh + Db + Dg + Dm + Df Aggregate Supply SA = Sh + Sb + Sg + Sm + Sf In equilibrium, DA = SA,Interest Rates,Quantity of Loanable Funds,Graphic Presentation,Loanable Funds Theory,Graphic Presentati

20、on When a disequilibrium situation exists, market forces should cause an adjustment in interest rates until equilibrium is achieved Example: interest rate above equilibrium Surplus of loanable funds Rate falls Quantity supplied reduced, quantity demanded increases until equilibrium,General Equilibri

21、um Interest Rate,Means of explaining how economic factors affect interest rate levels Interest rate level where quantity of aggregate loanable funds demanded = supply Surplus and shortage conditions Surplus- Quantity demanded quantity supplied followed by market interest rate increases,2. Interest R

22、ate Changes-Economic forces that affect interest rate,+ 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 (money policy and foreign flows of funds),2.1 Economic Forces That Af

23、fect Interest Rates,Economic Growth (focus on demand for) Expected impact is an outward shift in the demand schedule without obvious shift in supply (Exihibit 2.9) New technological applications with +NPVs Result is an increase in the equilibrium interest rate Explain how slowdown in the economy wou

24、ld affect the demand and supply schedules (Exhibit 2.10),2.2 Economic Forces That Affect Interest Rates: The Fisher Effect,Lenders want to be compensated for expected loss of purchasing power (inflation) when they lend Suppliers may reduce their saving Demanders may willing to borrow more funds Nomi

25、nal Interest Rates = Sum of real rate plus expected rate of inflation,Economic Forces That Affect Interest Rates,Inflation The Fisher Effect (A theory describing the long-run relationship between inflation and interest rates.) Nominal Interest Rates = Sum of Real Rate plus Expected Rate of Inflation

26、 This equation tells us that, all things being equal, a rise in a countrys expected inflation rate will eventually cause an equal rise in the interest rate (and vice versa). Offers an additional explanation for interest rate movements,in,ir,E(I),+,=,Figure 2.12 here,Economic Forces That Affect Inter

27、est Rates,Inflation If inflation is expected to increase 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, ra

28、ising the equilibrium rate Question: if inflation is expected inexactly ,who will get benefit?,2.3 Economic Forces That Affect Interest Rates,Money Supply (focus on supply of) When the Fed increases the money supply, it increases supply of loanable funds Places downward pressure on interest rates Ex

29、plain the examples (Weak Economy in 2001-2002, Impact of 9.11),2.4 Economic Forces That Affect Interest Rates,Federal Government Budget Deficit (focus on demand for) Increase in deficit increases the quantity of loanable funds demanded Demand schedule shifts outward, raising rates Government is will

30、ing to pay whatever is necessary to borrow funds, “crowding out” the private sector,2.4 Economic Forces That Affect Interest Rates,Crowding out Effect An economic theory explaining an increase in interest rates due to rising government borrowing in the money market. Governments often borrow money (b

31、y issuing bonds) to fund additional spending. The problem occurs when government debt crowds out private companies and individuals from the lending market. Increased government borrowing tends to increase market interest rates. The problem is that the government can always pay the market interest ra

32、te, but there comes a point when corporations and individuals can no longer afford to borrow.,2.5 Economic Forces That Affect Interest Rates,Foreign Flows (Exhibit 2.16) In recent years there has been massive flows between countries Driven by large institutional investors seeking high returns They i

33、nvest 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,Summary of Forces that affect Interest Rates,Economic condi

34、tions-supply of funds provided by households and demand for funds by all sectors Fiscal policy (tax policy)-level of disposable income so affect supply of funds and indirectly affected demand for funds Fed monetary policy-supply of funds and indirectly affected demand for funds Foreign flow of funds (foreign economic conditions)-supply of funds See Exhibit 2.17,3. Forecasting Interest Rates,Attempts to forecast demand/supply shifts With