Market Ch02
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Transcript of Market Ch02
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Determination of Interest Rates
2
2003 South-Western/Thomson Learning
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Explain Loanable Funds Theory of Interest Rate Determination
Identify Major Factors Affecting the Level of Interest Rates
Explain How to Forecast Interest Rates
CHAPTER OBJECTIVES
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Household Sector--Usually a net supplier of loanable funds
Business SectorUsually a net demander in growth periods
Government Sectors- Borrow for capital projects and deficit spending
Foreign SectorsNet supplier since early 1980s
SECTORS OF THE ECONOMY
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Households demand loanable funds to finance housing, automobiles, household items
These purchases result in installment debt. Installment debt increases with the level ofincome
There is an inverse relationship between the interest rate and the quantity of loanablefunds demanded
LOANABLE FUNDS
THEORY:
DEMAND FORLOANABLE FUNDS
Household Demand for Loanable Funds
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LOANABLE FUNDS THEORY:DEMAND FOR LOANABLE FUNDS
Businesses demand loanable funds to invest in assets
Quantity of funds demanded depends on how many projects to be
implemented. Businesses choose projects by calculating the projectsNet Present Value
If interest rates decrease, more projects will have a positive NPV.There is an inverse relationship between interest rates and the quantity
of loanable funds demandedBusinesses will need a greater amount of financing
Businesses will demand more loanable funds
n
t
t
t
k
CFNPV
0 )1(
Business Demand for Loanable Funds
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Municipal (state and local) governments issue municipal bonds
Federal government and its agencies issue Treasury securities and federal agencysecurities.
LOANABLE FUNDS
THEORY:
DEMAND FORLOANABLE FUNDS
Government Demand for Loanable Funds
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When planned expenditures exceed revenues from taxes, thegovernment demands loanable funds
Federal government expenditure and tax policies are independent ofinterest rates. Government demand for funds is interest-inelastic
LOANABLE FUNDS
THEORY:
DEMAND FORLOANABLE FUNDS
D
Interest
Rate
Quantity of Loanable Funds
Government Demand for Loanable Funds
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The aggregate demand for loanable funds is the sum of the quantities demanded by theseparate sectors
The aggregate demand for loanable funds is inversely related to interest rates
LOANABLE FUNDS
THEORY:
DEMAND FORLOANABLE FUNDS
Aggregate Demand for Loanable Funds
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DEMAND FOR LOANABLE FUNDS
Interest
Rate
Quantity of Loanable Funds
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Households are major suppliers of loanable funds
Businesses and governments may invest (loan) funds temporarily
Foreign sector a net supplier of funds
Variables other than interest rate changes causes a shift in the supply curve
SECTOR SUPPLY OF LOANABLE FUNDS
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Equilibrium Interest Rate
Aggregate Demand
DA
= Dh+ D
b+ D
g+ D
m+ D
f
Aggregate Supply
SA= Sh+ Sb+ Sg+ Sm+ Sf
In equilibrium, DA= SA
LOANABLE FUNDS THEORY
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Demand forLoanable Funds
Supply of
Loanable Funds
Interest
Rates
Quantity of Loanable Funds
GRAPHIC PRESENTATION
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oIn case of debt capital, cost of money refers to the interest rate.
oIn case of equity capital, cost of money is the required return. This is thereturn expected by the shareholders to leave the share price unchanged.
THE COST OF MONEY
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i
EFFECTS OFINCREASED RISK
ON COST OFMONEY: LOANABLE
FUND THEORY
D (Investment)
S (Savings)
k
Quantity of Loanable Fund
S1
D1
k1
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Inflation
The Fisher Effect: in=ir+E(Inflation)
Nominal Interest Rates = Sum of Real Rate plus Expected Rate of 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, raising the equilibrium rate
ECONOMIC FORCES THAT AFFECTINTEREST RATES
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Money Supply
When the Fed increases the money supply, it increases supply ofloanable funds. Places downward pressure on interest rates
Government Budget Deficit
Increase in deficit increases the quantity of loanable fundsdemanded. Demand schedule shifts outward, raising rates
Government is willing to pay whatever is necessary to borrowfunds, crowding out the private sector
ECONOMIC FORCES THAT AFFECTINTEREST RATES
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Foreign Flows
In recent years there has been massive flows between countries
Driven by large institutional investors seeking high returns
They invest 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 theworld
ECONOMIC FORCES THAT AFFECTINTEREST RATES
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Attempts to forecast demand/supply shifts
Forecast economic sector activity and impact upon demand/supply ofloanable funds
Forecast incremental effects on interest rates
Forecasting interest rates has been difficult
FORECASTING INTEREST RATES
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Economic GrowthIncreased growth; increaseddemand for funds; interest rates increase
Expected inflation--security prices fall; interest ratesincrease
Government budgets
Deficitincrease borrowing; security prices fall, interest ratesincrease
Surplusdecreased borrowing; security prices increase; interestrates decrease
Increased foreign supply of loanable fundssecurity
SUMMARY: KEY FACTORSIMPACTING INTEREST RATES OVER
TIME