Scribd
Upload
63 views4 pages

Chapter Two Determination of Interest Rates

This document discusses factors that influence the demand and supply of loanable funds, and how they determine equilibrium interest rates. It outlines household, business, and government demand for loans, as well as the supply of funds from savers. It then explains how economic conditions, inflation expectations, and the Fisher effect can cause shifts in demand and supply and impact interest rates. Equilibrium is reached when demand and supply are equal at a given interest rate.

Uploaded by

May Alanbaie
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
63 views4 pages

Chapter Two Determination of Interest Rates

This document discusses factors that influence the demand and supply of loanable funds, and how they determine equilibrium interest rates. It outlines household, business, and government demand for loans, as well as the supply of funds from savers. It then explains how economic conditions, inflation expectations, and the Fisher effect can cause shifts in demand and supply and impact interest rates. Equilibrium is reached when demand and supply are equal at a given interest rate.

Uploaded by

May Alanbaie
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 4

Chapter Two

Determination of Interest Rates


 Loanable funds theory: used to explain interest rates movements.
 Factors control demand and supply for loanable funds.
 “Demand for loanable funds”: refer to the borrowing activities households, businesses
and governments.

1. Household Demand for Loanable: to finance housing expenses+ finance household


items in installments.

 Aggregate level of household income rises over time so does installment debt.
 Level of installment debt generally lower in recessionary times.
 Inverse relationship between interest rates and the quantity of loanable funds
demanded= house demand would be greater at lower rates interest

2. Business Demand for Loanable Funds: to invest in long term (fixed) and short.
 The quantity demand depends on number of projects to be implemented
 LT Positive NPV accepted if higher than costs.
n CFt
NPV= - Inv + ∑ ----------
t=1 (1+k)t
 ST = to fund business operations
 Opportunity costs of investing in short-term assets is higher when interest rates are
higher.
 Businesses demand more money when interest rates are lower.

 Shifts in the demand for loanable Funds: in good economic times expected cash
flows on various proposed projects will increase

 More projects will expect higher rates of return than required rates: Hurdle rate
3. Government Demand For Loanable Funds:
 If taxes are not enough, it demands laonable funds.
 Funds obtained by bond issuing by state and local, federal issue TBs.
 Fed. Expenditures and taxes are independent of interest rates (demand for funds
is interest-inelastic. Some time municipals postpone demand for fund s and that
makes interest sensitive. Gov. demand for funds can shift if new bonds are issued

4. Foreign Demand for Funds: in any market foreign demand is included


 Foreign demand is influenced by the difference between the interest rates in each
country (inverse relation)
 If interest rates in a foreign country rises the demand for US dollar will shift
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

 Aggregate Demand for Loanable Funds: the sum of quantities of demanded funds
by various economic sectors at any given interest rate
 Aggregate demand is inversely related to interest rates at any point in time
 If the demand of any sector changes the aggregate demand changes

5. Supply of Loanable Funds: funds provided to financial markets by savers


 Household sector is the largest supplier of funds
 Government and business represent the net demanders of loanable funds
 If interest rates are higher, suppliers are more willing to supply funds
 Foreign, governments and businesses supply funds to their domestic markets by
purchasing domestic securities
 The large supply of funds to US is attributed to the high savings rates of foreign
households
 H.H will keep supplying even if interest rates are low, they postpone
consumption
6. Effects of the Fed:
 The supply of loanable funds is also affected by fed monetary policy. The policy is to
control economic conditions.
7. Aggregate Supply of Funds: aggregate supply of the quantity of loanable funds is
expected to be less sensitive to (inelastic) interest rate but aggregate demand for loanable
funds is interest sensitive (elastic)
 If interest income tax is decreased, then supply will be affected
 Financial institutions, although they channel funds they are not the ultimate suppliers
of funds (funds come from H.H, businesses and gov.

8. Equilibrium Interest Rates:


 Although there are many interest rates for different borrowers, interest rates across
borrowers tend to change in the same direction
 Equilibrium interest rate is the rate that equates AD with AS for funds

Agg. Demand = DA = Dh + Db + Dg + Dm +Df

Agg. Supply = SA = Sh + Sb + Sg + Sm + Sf

Equilibrium Interest rate = DA + SA

 If DA increases without increase in SA, there will be shortage in loanable funds =


Int. rates will rise because DA > SA
 If SA increases without increase in DA, there will be surplus in loanable funds =
Int. rates will fall because DA< SA
 DA and SA are changing

9. Economic Forces That Affect Interest Rates:

First we identify economic forces that cause the change in DA and SA and therefore
influence interest rates
A. Impact of Economic Forces: economic condition cause shifts in Agg. Demand and
supply of loanable funds which affects equilibrium interest rates.
 In good economic conditions, businesses tend to expand their business
activities therefore demand more funds at any level of interest rates forcing
demand to shift upward
 In good economic conditions, households will increase their savings
therefore supply of funds will at any level of interest rates forcing supply to
shift upward
 Economic growth puts upward pressure on interest rates
 Economic slowdown puts downward pressure on interest rates
 Business expansion will cause increase in demand but no obvious change in
supply

B. Impact of Inflation on Interest Rates:


 Changes in inflationary expectation can affect interest rates by affecting the
amount of spending by H.H and businesses.
 Decisions to spend affect the amount of saved and amount borrowed.
 If inflation is expected to rise, H.H reduce their savings at any interest rate so
they can make more purchases now before prices rise.
 In this case supply will shift inward.
 H.H and businesses might be willing to borrow more funds at any interest rate
level so they can purchase prices increase.
 Demand will shift downward.
 Equilibrium interest rate is higher

C. Fisher Effect:

You might also like

pFad - Phonifier reborn

Pfad - The Proxy pFad of © 2024 Garber Painting. All rights reserved.

Note: This service is not intended for secure transactions such as banking, social media, email, or purchasing. Use at your own risk. We assume no liability whatsoever for broken pages.


Alternative Proxies:

Alternative Proxy

pFad Proxy

pFad v3 Proxy

pFad v4 Proxy