Chapter 5McGraw Hill / Irwin
Eighth Edition
Peter S. Rose
McGraw Hill / Irwin
The Determinants of Interest Rates: Competing Ideas
2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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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.
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5 - *
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.
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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.
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 serves as an important tool for government policy through its influence on the volume of savings and investment.
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.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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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.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Substitution Effect
Interest
Rate
Current
Saving
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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).
2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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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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The Cost of Capital and the Investment Decision
A
15%
B
12%
C
10%
D
8%
E
7%
Expected Internal Rates of Return on Alternative Investment Projects
Cost of Capital Funds = 10%
C
10%
D
8%
E
7%
– acceptable
– acceptable
– indifferent
unprofitable
unprofitable
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The Investment Demand Schedule

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The Equilibrium Rate of Interest
In the Classical Theory of Interest Rates
Interest
Rate
Savings &
Investment
rE
QE
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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.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Classical Theory of Interest Rates
In addition to the business sector, both consumers and governments are also important borrowers today.
Limitations … continued
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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).
2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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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.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Total Demand for Money or Cash Balances
in the Economy
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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.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Equilibrium Interest Rate
Interest
Rate
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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.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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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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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.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Interest
Rate
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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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The Loanable Funds Theory of Interest
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.
The Supply of Loanable Funds … continued
2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Interest
Rate
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The Equilibrium Interest Rate
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At equilibrium:
Money supply = money demand
2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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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.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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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.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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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
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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.
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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.
2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Money and Capital Markets in Cyberspace
Many websites explore topics related to interest rates. See, for example,
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The Classical Theory of Interest Rates
Savings by Households, Business Firms and Governments
The Demand for Investment Funds
The Equilibrium Interest Rate
2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Liquidity Preference or Cash Balances Theory of Interest Rates
The Demand for Liquidity
The Equilibrium Interest Rate
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The Demand for Loanable Funds
The Supply of Loanable Funds
The Equilibrium Interest Rate