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Lecture 2

Determination of Interest Rates

Angeliki Theophilopoulou

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Determination of Interest RatesOutline

y Loanable funds theory

y Economic forces that affect interest rates

y Forecasting interest rates

Reading:y Madura 2008,ch.2

Additional Reading:

y I

nflation Report from Bank of Englandy Mishkin & Eakins, ch. 4, 5th edition

y Yvon Fauvel & Alain Paquet & Christian Zimmermann, 1999. "ASurvey on Interest Rate Forecasting," Cahiers de recherche CREFE/ CREFE Working Papers 87, CREFE, Universit du Qubec Montral.

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Loanable Funds Theoryy Loanable funds theorysuggests that the market

interest rate is determined by the factors that

affect the supply of and demand for loanable funds

y Can be used to explain movements in the general levelofinterest rates of a particular country

y Can be used to explain why interest rates among debtsecurities of a given countryvary

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Aggregate Demand for Loanable

FundsyHousehold demand for loanable funds

yHouseholds demand loanable funds to

finance:y Housing expenditures

y Automobiles

y Household items

yThere is an inverse relationship between theinterest rate and the quantity of loanablefunds demanded

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Aggregate Demand for Loanable

Funds (contd)yBusiness demand for loanable funds

y Businesses demand loanable funds to invest in fixed assets

and short-term assetsy Businesses evaluate projects using net present value (NPV):

y Projects with a positive NPV are accepted

y There is an inverse relationship between interest rates and

business demand for loanable funds

!

!

n

t

t

t

k

CFINVNPV

1 )1(

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Aggregate Demand for Loanable

Funds (contd)y Government demand for loanable funds

y Governments demand funds when planned

expenditures are not covered by incoming revenuesy Municipalities issue municipal bonds (US)

y The government issues Treasury securities

y Gilts are bonds issued by the governments of the UnitedKingdom, South Africa, or Ireland.

y Government demand for loanable funds isinterest-inelastic

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UK Public Sector Net Borrowingy Measured in millions of pounds sterling

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Aggregate Demand for Loanable

Funds (contd)yForeign Demand for loanable funds

y Foreign demand for U.K. funds is influenced bythe interest rate differential betweencountries

y The quantity ofU.K. loanable funds

demanded by foreign governments or firms isinversely related to U.K. interest rates

y The foreign demand schedule will shift inresponse to economic conditions

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Aggregate Demand for Loanable

Funds (contd)yAggregate demand for loanable funds

y The sum of the quantities demanded by theseparate sectors at any given interest rate isthe aggregate demand for loanable funds

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Aggregate Demand for Loanable

Funds (contd)

Dh

Household Demand

Db

Business Demand

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Aggregate Demand for Loanable

Funds (contd)

Dg

Government Demand Foreign Demand

Df

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Aggregate Demand for Loanable

Funds (contd)

DA

Aggregate Demand

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Aggregate Supply for Loanable

Funds (contd)ySupply of loanable funds (contd)

y Foreign households, governments, and

corporations supply funds by purchasingdomestic corporate and Treasury securitiesy The supply is influenced bymonetarypolicy

implemented by the Central Bank (BoE)y The BoE controls the amount of reserves held by

depository institutionsy The supply curve can shift in response to

economic conditionsy Economic growth, taxation etc,.

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Aggregate Supply for Loanable

Funds (contd)

SA

Aggregate Supply

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Equilibrium of Loanable Funds-

interest rateyEquilibrium interest rate - algebraic

y The aggregate demand can be written as

y

The aggregate supply can be written as

fmgbhA DDDDDD !

fmgbhA SSSSSS !

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Equilibrium of Loanable Funds-

interest rate

SA

Equilibrium Interest Rate - Graphic

DA

i

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Economic Forces That Affect Interest Rates

yEconomic growthy Shifts the demand schedule outward (to the

right)y There is no obvious impact on the supply

scheduley Supply could increase if income increases as a result of

the expansiony The combined effect is an increase in the

equilibrium interest rate

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Loanable Funds Theory (contd)SA

Impact of Economic Expansion

DA

i

DA2

i2

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Loanable Funds Theory (contd)SA

Impact of Expected Increase in Inflation

DA

i

DA2

i2

SA2

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Chart 2: CPI inflation projection based on markets

interest rates expectations and 200 billion asset

purchases

From BoE Inflation Report, November 2010

Which factors will affect inflation in 2011 for the UK?

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Fed target rate and price of crude

oil

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Economic Forces That Affect Interest Rates

(contd)

yFisher effecty Nominal interest payments compensate savers

for:

y Reduced purchasing power

yA premium for forgoing present consumption

y The relationship between interest rates andexpected inflation is often referred to as theFisher effect

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Economic Forces That Affect Interest

Rates (contd)yFisher effect (contd)

y Fisher effect equation:

y The difference between the nominal interest rate andthe expected inflation rate is the real interest rate:

y Real interest rate more accurately reflects true cost ofborrowing

yWhen real rate is low, greater incentives to borrow andless to lend

R

iINFEi !)(

)(INFEiiR

!

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Economic Forces That Affect Interest

Rates (contd)

yFisher effect (contd)y If the actual inflation rate is higher than

anticipated then borrowers benefit :it+1Et(it+1)

y Forecasting inf lation is crucial

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Distinction Between Real

and Nominal Interest Rates

If i = 3% E(i fl ti )= 1% t

ir = 3% - 1% = %

If i = 3% E(i fl ti ) = 3.5% t

ir = 3% - 3.5% = - .5 %

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Distinction Between Real

and Nominal Interest Rates

29The nominal interest rate shown here is the rate on US government five-year bonds. The inflation rate representsannual growth in the consumer price index. Source : J.F Nadeau 2009.

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Economic Forces That Affect Interest Rates

(contd)

yMoney supplyy If the CB increases the money supply, the supply

of loanable funds increasesy If inflationary expectations are affected, the demand

for loanable funds may also increase

y If the CB reduces the money supply, the supplyof loanable funds decreases

y The equilibrium interest rate goes up.

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Money Supplyy The total amount of money in the economy at a

particular point of time.

y

Definition for the UKy M0,monetary base:Cash outside Bank of England +Banks' operational depositswith Bank of England.

y M4, broad money:Cash outside banks (ie. in

circulation with the public and non-bank firms) +private-sector retail bank and building societydeposits + Private-sector wholesale bank and buildingsocietydeposits and Certificate of Deposit.

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B f E gl B R t

Source: Bank of England 2009

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Economic Forces That Affect Interest Rates

(contd)

yMoney supply (contd)y September 11 2001

y Firms cut back on expansion plansy Households cut back on borrowing plans

y The demand of loanable funds declined

y Theweak economy in 20012002y Reduced demand for loanable fundsy The CB increased the money supply growth

y Interest rates reached very low levels

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M4 for UK

-5

5

10

15

0

25

30

Oct-82

Oct-83

Oct-84

Oct-85

Oct-86

Oct-87

Oct-88

Oct-89

Oct-90

Oct-91

Oct-92

Oct-93

Oct-94

Oct-95

Oct-96

Oct-97

Oct-98

Oct-99

Oct-00

Oct-01

Oct-02

Oct-03

Oct-04

Oct-05

Oct-06

Oct-07

Oct-08

Series1

3 th growthrate(annualised)of M4

(monetary financial institutions'sterling M4 liabilitiesto rivatesector)(in

ercent)seasonallyadjusted, BoE

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UK 12 month growth rates of notes and coins

(Seasonally adjusted)

Source: Bloomberg 2009

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Economic Forces That Affect Interest Rates

(contd)yBudget deficit

yA high deficit means a high demand for loanablefunds by the governmenty Shifts the demand schedule outward (to the right)y Interest rates increase

y The government may be willing to pay whatever isnecessary to borrow funds, but the private sector

may noty Crowding-out effecty The supply schedule may shift outward if the government

creates more jobs by spending more funds than it collectsfrom the public (but in a smaller effect)

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Economic Forces That Affect Interest Rates

(contd)

yForeign flows of fundsy Shifts in the flows of funds between countries cause

adjustments in the supply of funds available in eachcountry

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Economic Forces That Affect Interest Rates

(contd)y Explaining the variation in interest rates over time

y Early 1980s: recession led to a decline in interest ratesy Late 1980s: interest rates increased in response to a strong

economyy Early 1990s: interest rates declined as a result of a weak

economyy 1994: interest rates increased as economic growth increased

y Drifted lower for next several years despite strong economic growth,partly due to the U.S. budget surplus

y 2001: interest rates decreased in response to pessimisticsentiments for the global economy.

y 2008: interest rates fall in historical lows trying to boost thelow economic activity and to combat the credit crunch andrecession.

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C

BsM

onetary Policy (target) rates

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Forecasting Interest Ratesy It is difficult to predict the precise change in

the interest rate due to a particular event

y Being able to assess the direction of supply ordemand schedule shifts can help inunderstanding why rates changed

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Forecasting Interest Rates (contd)y To forecast future interest rates, the net demand

for funds (ND) should be forecast:

? A

? Afmgbh

fmgbh

AA

SSSSS

SN

!

!

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Forecasting Interest Rates (contd)yApositive disequilibrium in NDwill be

corrected by an increase in interest rates

yAnegative disequilibrium in NDwill becorrected by a decrease in interest rates

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