Financial institutions and market

2024
Chapter Three
Interest Rates in the Financial System
I. General
The acts of saving, lending, borrowing and investment are intimately linked through the financial
system.
 Clearly one factor that significantly influences all of them, i.e., saving, lending,
borrowing, and investment, is the rate of interest.
The rate of interest is the price a borrower must pay to secure scarce loan able funds from a
lender for an agreed period of time,
 It is the price of credit.
But unlike other prices in the economy, the rate of interest is really a ratio of two quantities – the
cost of money borrowed to the amount of money actually borrowed, usually expressed on an
annual percentage. That is,
Interest rate (or cost of credit) = cost of money borrowed
Amount of money Actually Borrowed
Interest rates, in general, send price signals to borrowers, lenders, savers, and investors.
Higher interest rates generally bring forth greater volume of savings and stimulate the
lending of funds.
Lower rates, on the other hand, tend to dampen the flow of savings and reduce lending
activity.
Higher interest rates tend to reduce the volume of borrowing and capital investment,
while lower rates stimulate borrowing and investment spending.
Due to its role in affecting mobilization of savings to investments, it is important to see what
factors believed by “economists” and “financial analysts" are forcing and help to determine
the rate of interest in the financial system.
II. Functions of interest rates in the economy
The rate of interest performs several important roles in the economy. The following are the main
ones:
 It helps to guarantee current savings will flow in to investment and hence promote
economic growth.

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 It rations the available supply of credit, generally providing loan able funds to investment
projects with the highest expected returns.
 It brings into balance the nation’s supply of money with the public’s demand for money.
 It is also an important tool for executing government policies & strategies through its
influences upon the volume of saving and investment. In this regard,
 If a given economy is growing slowly and experiencing rising unemployment, then
the government might lower interest rates in order to stimulate borrowing and
investment; and
 Conversely, if a given economy is better growing yet experiencing rapid (high)
inflation, then the government might increase interest rates in order to slow both
borrowing and spending.
In discussing the general and pervasive rate-determining forces, however, we need to make a
simplifying assumption.
 To this end, let us assume that there is one fundamental interest rate in the economy
known as the pure or risk-free rate of interest, which is a component of all rates.
 Risk-free rate of interest is a rate of return presenting little or no risk of financial loss to
the investor and represents the opportunity cost of holding idle money because investor
can always invest in government treasury bills & government agency bonds and earn this
minimum rate of return.
Once the pure rate of interest is determined, all other interest rates may determined from it by
examining the special characteristics of the securities issued by individual borrowers.
 Differences in liquidity, marketability, and maturity are other important factors causing
interest rates to differ from the pure, risk-free rate.
3.1 The Theory and Structure of Interest Rates
There are several theories of interest rates and their implications in the financial system. Among
these theories, the following four are the common and as well as popular ones as believed by
economists and financial analysts;
1. The Classical Theory of Interest Rates
2. The liquidity Preference Theory of Interest Rates
3. The Loan able funds Theory of Interest Rates
4. The Rational Expectations Theory of Interest Rates

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3.1.1 The Classical Theory of Interest Rates

It is one of the oldest theories concerning the determinants of the risk-free interest rate. The
classical theory argues that the rate of interest is determined by two forces:
 The supply of saving, derived mainly from households, and
 The demand for investment capital coming mainly from the business sector
1. supply of saving
A. savings by house holds
Most savings in modern industrialized economies is carried out by individuals and families.
 For these households, saving is simply abstinence from consumption (spending).
Mathematically,
Current Savings = Current Income - Current Consumption Expenditure
In general, different factors affect the timing & amount of savings by households. In this regard,
the following are the basic factors considered by households while making decisions on the
timing and amount of savings:
Size of current and long-term income,
The desired savings target, and
The desired proportion of income to be saved (i.e., the propensity to save).
Apparently, the volume of savings by households increases with higher income. In this regard, it
appears that
 Higher-income families and individuals tend to save more and consume less relative to
their total income than families with lower income.
 Interest rates also affect individuals’ choice between current consumption and savings for
future consumption.
The classical theory is not freed from assumptions. In this regard, the following are the
underlying assumptions of the classical theory of interest rates;
Individuals have a definite time preference for current over future consumption;
A rational individual would always prefer current enjoyment of goods and services over
future enjoyment;
Therefore, the only way to encourage an individual of family to consume less now and
save more was to offer a higher rate of interest on current savings; and

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If more were saved in the current period at a higher rate of return, future consumption and
future enjoyment would be increased.
According to the classical theory, thus,
 Payment of interest is a reward for waiting – that is, the postponement of current
consumption in favor of greater future consumption.
 Higher interest rates, presumably,
 Increase the attractiveness of savings relative to spending;
 Encourage more individuals to substitute savings for current consumption (i.e. to
sacrifice current consumption in order to make savings that, in turn, creates
additional consumption stream in the future);
 This is so called the " substitution effect", that calls for a positive relationship
between interest rates and the volume of savings; and
 The conclusion is that higher interest rate brings forth a greater volume of savings
in the economy.

Interest Rates I2

I1

S1 S2 (Volume of current savings)

B. Savings by Business Firms

Businesses also save and/or direct a portion of their savings in to the financial markets to
purchase securities and make loans.
 Temporary cash surpluses often are invested in money market instrument.
 Businesses hold long run savings balance in the form of retained earnings.
The increase in retained earnings of businesses is a key measure of the volume of current
businesses saving. In this regard, the volume of business savings depends up on;
 The level of business profits, and

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 The dividend policies of corporations.
These two factors are summarized in what we call the retention ratio. The retention ratio, in this
regard, indicates the proportion of current business profits to be retained in order to undertake
future investments of different sort.
 The retention ratio often is kept the same (constant); and in some firms it is increased
from time to time.
 Many corporations generally prefer to keep and/or increase payment of dividends.
Therefore, the critical element in determining the amount of business saving is the level of
business profits as most firms prefer to keep on paying or increase the payment of dividends as
well as maintain constant of increasing retention ratio.
 When profits are expected to rise, then
 Businesses obtain large funds internally;
 Draw less funds from money and capital markets;
 Results in reduction in the demand for credit; and
 Ultimately, brings forth a tendency toward lower interest rates.
 When profits fall but firms do not cut back on their investment plants, then
 They will be forced to make heavier use of money and capital markets for
investment funds;
 The demand for credit rises; and
 Interest rates, therefore, rises.
Interest rates also play a role in the decision of what proportion of current operating costs and
long- term investment expenditures should be financed internally and what proportion externally.
In general,
 Higher rates encourage firms to use internally generated funds; whereas
 Lower rates encourage greater use of external funds.
C. Savings by Governments
Governments also save, though less frequently and generally in smaller amounts than others. In
this regard, government saving:
 Mostly are in the form of a budget surpluses,
 Are unintended savings (funds saved not intentionally/unplanned savings), and

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 Arises when government receipts unexpectedly exceed the actual amount of
expenditures.
Factors affecting the level of government saving are the following:
 Income flows in the economy (out of which government tax revenues arise),and
 The pacing of government spending programs.
In general, interest rates are probably not key factors in affecting government savings.
2. The Demand for Investment Funds
I. General
According to the classical theory of interest, savings made by households, businesses, and the
government are important determinants of interest rates in an economy.
 But these savings are not the only ones in determining interest rates.
 Other critical rate-determining factor in the classical theory is “the level of investment
spending by business firms” in an economy.
Generally speaking, businesses require huge amount of funds each year to purchase fixed assets.
 The majority of business expenditures for these purposes consist of what economists call
Replacement Investment.
 A smaller, but more dynamic, from of business capital spending is labeled Net
Investment, expenditure to acquire additional fixed assets in order to expand out puts.
Therefore, Gross Replacement Net
Investment = Investment + Investment
Replacement investment is usually more predictable and grows at a more even rate.
 This is due to the fact that such expenditures are financed exclusively from inside the
firm; and
 Replacement investments frequently follow a routine pattern.
Net investment, however, depends on:
 The business community outlook regarding future sales;
 Changes in technology
 Industrial capacity; and
 The cost of raising fund.
 These factors are subject to frequent changes
 Thus, net investment (particularly inventory investment) is highly volatile.

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Net investment, because of its total size and volatility, is a driving force in the economy. In this
regard, changes in net investment are closely linked to;
 Fluctuations in the nation’s output of goods and services,
 Employment, and
 Prices.
Unless offset by increased consumption or government spending otherwise, a significant decline
in net investment frequently leads to;
 A business recession,
 A decline in productivity, and
 A rise in unemployment.
II. Investment Demand for funds
A. The Investment Decision Making Process

Investment decision-making by business firms is complex and depends on a host of qualitative

and quantitative factors. To this effect, we need to, for instance, perform the following before
making investment decisions;

 Compare current level of production with existing capacity;

 Decide whether sufficient (and/or excess) capacity exists to handle anticipated demand;
and so on.
If larger demand is anticipated, this will make the firm expand operating capacity through net
investment. In this regard, management (and/or project analysts) needs to
 Estimate expected rate of return from investments and compare the projected return with
anticipated returns from alternative projects, and as well.
 Determine the internal rate of return (IRR) of the project (s).
 The IRR, being one of the investment appraisal criteria, measures the annual yield
the firm expects from investments.
 The IRR is used to compare and contrast alternative projects vis-à-vis the cost of
capital, the letter is the rate one uses to determine the NPV (i.e. Net Present Value
projects) or present value of future/ investment benefits.

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B. Investment Demand and the rate of Interest
Classical economists argue that the demand for investment capital by business firms is
negatively related to the rate of interest.
The next graph depicts the inverse relationship existing between the volume of investment
spending and the level of interest rates in the economy.
 At lower rates of interest, in this case at i 1 more investment projects become
economically viable and firms require more funds to finance a longer list of projects,
which is reflected in IS1.

Investment (I)

i2

Interest Rate

i1

IS2 IS1 (Volume of Investment spending)

The converse is also true when interest rates rises to higher levels; that is, at i 2 only few
investment projects become economically viable and firms require less amount of funds to
finance small number of projects, which is reflected in IS2 .
3. Equilibrium Rate of Interest
The classical economists believed that interest rates in the financial markets were determined
by the interplay of the supply of savings and the investment demand for funds. The following
graph depicts the equilibrium rate of interest versus the equilibrium volume of investment
spending.
Demand for Investment funds
S

Interest rate E

IE supply of Savings

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I

QE

Volume of savings and Investment (in Millions of Birr)

As a matter of fact, the market rate of interest always moves towards its equilibrium level (i.e., to
IE).
 At any given time, the rate of interest is probably above or below its true equilibrium
level, but moving towards the equilibrium due to changing supply and demand forces.
 If the market rate of interest lay temporarily above equilibrium, then
 The volume of savings will exceed the demand for investment capital;
 This creates excess supply of savings; and
 Saver will offer their funds at lower and lower rates until the market interests rate
approaches equilibrium.
 Conversely, if the market rate of interest lay temporary below equilibrium, then
 Investment demand for funds will exceed the quantity of savings available; and
 Business firm’s bid up the interest rate until it approaches the level at which the
quantity of funds saved equals the quantity of funds demanded for investment
purposes.
4. Limitations of the Classical Theory of Interest Rates
The classical theory sheds considerable light on the factors affecting interest rates. However, it
has some serious limitations. These are;
(A) The classical theory of interest rates ignores several factors other than saving and
investment that affect interest rates.
 For instance, the amount of money created or destroyed affects the total amount of
credit available in the financial market place and, therefore, must be considered in
any explanation of the factors determining interest rates.
(B) It assumes that interest rates are the principal determinant of the volume or quantity of
savings in an economy.
 Today, however, economists recognize that income is far more important in
determining the volume of savings than interest rates.

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(C) The theory contents that the demand for borrowing funds comes principally from the
business sector.
 Today, however, both consumers and governments are important borrowers, the
acts of which significantly affecting the availability and costs of credit.
(D) The classical theory, moreover, focuses on a long run explanation of interest rates, the
factors being considered, in this regard, tend to change slowly. For instance, the
following factors tend to change slowly in the economy.
 Public’s thrift habits (avoiding extravagancies or carefulness in savings), and
 Productivity of capital.
3.1.2 The Liquidity Preference Theory
During the 1930s the British economist John Maynard Keynes developed a short-run theory of
the rate of interest which, he argued, was most relevant for
 Policy makers, and
 Explaining near-term changes in interest rates.
This theory is known as the liquidity preference theory of interest rates.
A. The Demand for Liquidity
1. Prelude
According to the argument of J.M. Keynes, the rate of interest is really a payment for the use of a
scarce resource-money.
 Businesses and individuals prefer to hold money for carrying out daily transactions and
also as a precaution against future cash needs even though its yield is low or nonexistent.
 Interest rates, therefore, are the price that must be paid to induce money holders to
surrender a perfectly liquid asset and hold other assets that carry more risk.
 At times the preference for liquidity grows very strong.
 Unless the government expands the nation’s money supply, interest rates will rise.
In the theory of liquidity preference, only two outlets for investor funds are available- Bonds
and Money (including bank deposits). In this regard,
 Money provides perfect liquidity (instant spending power) to the holder.
 Bonds pay interest but cannot be spent until converted in to cash.
It is true that bond prices rise or fall depending on changes in the rate of interest in the economy.
To this effect,

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 If interest rates rise, the market value of bonds paying a fixed rate of interest will fall.
 The investor would suffer a capital loss if those bonds were converted in to cash.
 On the other hand, a fall of interest rates results in higher bond prices.
 The bond holder will experience a capital gain if the bonds are sold for cash.
To the classical theorists, it was irrational to hold money because it provided little or no return.
 To Keynes, however, the holding of money could be a perfectly rational act if interest
rates were expected to rise.
 This because rising rates could result in substantial losses from investing in bonds.
2. Motives for Holding Money
With regard to motives for holding money, Keynes observed that the public demands money for
3 motives. These are;
 Transaction Motives,
 Precautionary Motives, and
 Speculative motive
Each of these motives for holding money and their implications to changes in interest rates is
discussed next.
i. Transaction and Precautionary Motives
The transaction motive represents the demand for money in order to purchase goods and
services.
 Businesses, households, and governments must keep some cash in their custody or in
demand deposit accounts simply to meet daily expenses. This is because of the following
two reasons;
 Inflows and outflows of money are not perfectly synchronized (either in their
timing or amount), and
 It is costly to shift back and forth between money and other assets.
 Thus, economic units must keep some cash for transaction purposes.
Some amount of money must also be held as a reserve for future emergencies and to cover
extraordinary expenses
 The precautionary motive, in this regard, explains this desire to hold money as a reserve
in order to meet contingencies (unexpected outlays) that normally arise as we live in a
world of uncertainty.

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 In fact, we cannot predict exactly what expenses or opportunities will arise in the future.
Keynes assumed money demand for transactions and precautionary purposes was dependent
upon the level of;
 National Income,
 Business Sales, and
 Prices
Reflecting money’s role as a medium of exchange, higher levels of income, sales, or prices
increased the need for money to carryout transactions and to respond to future expenses and
opportunities.
 However, neither the precautionary nor the transaction demand for money was assumed
to be affected by changes in interest rates.
 To this effect, Keynes assumed money demand for precautionary and transactions
purposes to be fixed in the short run.
 In a longer run period, however, transactions and precautionary demands changes as
national income changes (also called "net interest ").
ii. Speculative Motive
Short run changes in interest rates where attributed by Keynes to another, third, motive for
holding money – the speculative motive- which stems from uncertainty about future prices
of bonds.
 If investors expect rising interest rates, then
 Many of them will demand money or near- money assets instead of bonds because
they believe bond prices will fall as mentioned earlier.
 As the expectation that interest rates will rise grows stronger and stronger in the
market place, the demand for money as a secure store of value increases.
 Conversely, if investor expect falling interest rates, then
 Many of them will demand bonds (or long-term debt securities) instead of money
or near-money assets as they believe bond prices will rise in the market place.
 As the expectation that interest rates will rise grows stronger and stronger in the
market place, the demand for money as a secure store of value increases.

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We may represent this speculative demand for money by a curve that slope down ward and to the
right reflecting a negative relationship between the speculative demand for money and the level
of interests’ rates. (The following graph depicts the relationship between interest rates and the
speculative demand for money.

High Demand for Bonds

Ds(Greater expectation of a decline in interest rate)

High Demand for Money

Interest rate (Greater expectation of a rise in interest rate)

Ds
Quantity of money Demanded for speculative purposes
(in millions of birr)
 At low rates of interest, many investors feel that interest rates are soon to rise (i.e.,
bond prices are going to fall) and, therefore, more money is demanded.
 At high rates of interest, on the other hand, many investors will conclude that rates
soon will fall and bond prices rise, so the demand for money decreases while the
demanded for bonds increases.
From another vantage point (or viewed in another way), when interest rates are high, the
opportunity cost (loss) from holding idle cash increases.
 Thus, high interest rates encourage investors to reduce their cash balances and buy bonds.
In contrast, when interest rates are low, the opportunity cost of holding idle cash in also low, but
the expected capital loss from holding bonds is high should interest rates rise.
 Thus, there is more incentive to hold money rather than buy bonds when interest rates are
low.
3. Total Demand for Money
The total demand for money in the economy is simply the sum of transactions, precautionary,
and speculative demands. The following graph depicts the relationship between the rate of
interest and transaction (T), precautionary (P), and speculative (S) demands for money in the
short run.

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Transaction &

Precautionary Speculative

Demand Demand

DT

0 K J

Because the principal determinant of transactions and precautionary demand is income, not
interest rates, these money demands are fixed at a certain level of national income.
 The transactions and precautionary demands are represented by the quantity of “OK” in
the above graph.
 Any amount of money demand in excess of OK represents speculative demand.
 The total demand for money is represented along curve DT
Therefore, if the rate of interest now is at I, the speculative demand for money is KJ and the
total demand for money is OJ.
B. The Supply of Money
The other major element determining interest rates in liquidity preference theory is the
supply of money.
 In modern economies, the money supply is controlled or at least closely regulated
by government.
 Because government decisions concerning the size of the nation’s money supply
presumably are guided by the public welfare and not by the level of interest rates,
we assume that the supply of money is inelastic with respect to the rate of interest.
Liquidity preference theory provides some useful insights in to investor behavior and the
influence of government policy on the economy and financial system.
 It suggest that it is rational at sometimes for the public to hoard money and at other
times to " dishoard" (spend away) unwanted cash.

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The liquidity preference theory reveals that how central banks, for instance, the Federal
Reserve System (in case of U.S.) and/or the National Bank of Ethiopia (NBE) influence
interest rates in the financial system (or markets) at least in the short-run.
 If higher interest rates are desired, the central bank can contract the size of the nation’s
money supply and rates will tend to rise, assuming the demand for money is unchanged.
 If the demand for money is increasing, then the central bank can bring about higher
interest rates by ensuring that the money supply grows more slowly than money demand.
 In contrast, if the central bank expands the nation’s money supply, interest rates will
decline in the short run if the demand for money does not increase as well.
 An increase in the nation’s money supply creates excess liquidity, at least temporarily
and hence, interest rates fall.
 However, the excess liquidity will generate additional spending in the economy, driving
up income and increasing the demand for money (increase in investment expenditures as
well as increases in employment & salary expenditure).
Unless the money supply expands further, the downward trend in rates will be
reversed and interest rates will begin rising.
 Finally, an increasing money supply coupled with rising income may generate
inflationary expectations.
Businesses and consumers come to expect rising prices, as do lenders of funds who,
therefore, raise interest rates on loans.
Thus, it is argued that, given sufficient time, income and price-expectations effects will offset the
liquidity effect of money supply changes.
 Interests may end up higher or lower than their initial level after a money supply
change, depending on the relative strengths of these three effects.
C. Limitations of the Liquidity Preference Theory
Like the classical theory of interest rates, the liquidity preference theory has important
limitations.
 In this regard, the liquidity preference theory of interest rates is a short-run approach to
interest rate determination because it assumes that income remains stable.
In the long run, of course, interest rates are affected by changes in the level of income and
price (inflationary) expectations.

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Indeed, it is impossible to have a stable equilibrium interest rate without also reaching an
equilibrium level of income, saving, and investment in the economy.
Then too, liquidity preference considers only the supply and demand for the stock of
money, whereas business, consumer, and government demands for credit clearly have an impact
upon the cost of credit to these borrowers.
 A more comprehensive view of interest rate is needed which consider the important roles
played by all actors in the financial system-that is, businesses, households, and government.
3.1.3 The Loan able Funds Theory
This view argues that the risk-free interest rate is determined by the interplay of two forces: the
demand for loan able funds and the supply of loan able funds.
 The demand for loan able funds consists of:
 Credit demands from domestic businesses, consumers, and units of government,
and borrowing in the domestic market by foreigners.
 The supply of loan able funds stems from four sources:
 Domestic savings,
 Hoarding demand for money, either positive hoarding, which reduces volume of
loan able funds or negative hoarding/dishoarding, which increases volume of loan
able funds,
 Money creation by the banking system, and
 Lending in the domestic market by foreign individuals & institutions.
1. Demands for Loan able Funds
A. Consumer Demand for Loan able Funds
Consumers require loan able funds in order to purchase a wide verity of goods & services on
credit.
 Largely, consumers are not particularly responsive to rate interest when they seek credit.
 Instead, they focus principally on the non-price terms of a loan such as down payment,
maturity, and the size of installment payments.
Consumer demand for credit is relatively inelastic with respect to the rate of interest.
 A substantial change in the rate of interest must occur before the quantity of consumer
demand for funds changes significantly.
B. Business Demand for Loan able funds

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Business credit demands are more responsive to changes in the rate of interest than is consumer
borrowing (in other words, it is affected by the rate of interest).
 Most business credit is for the acquisition of fixed assets and inventories
 The quantity of loan able funds demanded by the business sector increases as the rate
of interest falls.
C. Government Demand for Loan able Funds
Government demand for loan able funds does not depend significantly on the level if interest
rates.
 Federal government decisions on spending & borrowing are made in response to social
needs and public welfare, not the rate of interest.
 Federal governments have power both to tax and to create money in order to pay debts.
 State& local government demand is slightly interest elastic.
 Because many of the state and local governments are limited in their borrowing
activities by legal interest rate ceilings.
When open market rates rise above the legal ceilings, such governmental units are prevented
from offering their securities to the public in order not to further increase rates and/or avoid deep
decline in value of securities.
D. Foreign Demand for Loan able Funds
Foreign banks, corporations, and foreign governments also enter to borrow funds in the domestic
market of a given economy.
This foreign credit demand is sensitive to the spread between the domestic lending rates
and interest rates in foreign markets.
If demotic interest rates decline relative to foreign rates, foreign borrowers will be inclined
to borrow more in the domestic market.
At the same time, with higher interest rates overseas, the demotic lending institutions will
increase their lending abroad and reduce the availability of loan able funds to domestic
borrowers.
The net result then is a negative or inverse relationship between foreign borrowing in the
domestic market and the domestic interest rates relative to foreign interest rates.
In a nut shell, the total demand for loan able funds is the sum of the four, which slops down ward
and to the right with respect to the rate of interest.

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 However, the demand for loan able funds alone dose determine the rate of interest; the
supply of loan able funds must be added to complete the picture.
 The following graph depicts the overall demand for loan able funds in the economy.

DLF

Interest Rate % Demand for loan able funds

(Summation of the demand for loan able funds by Consumer,
Business firm, Government and Foreigners

Volume of Loan able funds

2. The Supply of Loan able Funds,

A. Domestic Savings
The supply of domestic savings is the principal source of loan able funds.
 As noted earlier, most saving is done by households and is simply the difference between
current income and current consumption.
 Businesses, however, also save by retaining apportion of current earnings and by adding
to depreciation reserves.
 Government savings, while relatively rare, occurs when current revenues exceed current
expenditures.
Earlier in this chapter it is noted that most economists today believe that income levels, rather
than interest rates, are the dominant factor in the decision of how much and when to save.
 There is, however, considerable controversy as to just what measure of income
determines the annual volume of savings.
Thus, a subsequent rise in interest rates will enable the savers to reach the goal with less sacrifice
of current income.
The net effect of income, substitution, and wealth effects leads to a relatively interest inelastic
supply of savings curve.

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 Substantial changes in interest rates usually are required to bring about any significant
changes in the volume of aggregate savings in the economy.
B. Dishoarding of Money Balances
The difference between the public’s total demand for money and the money supply is known as
hoarding.
 When the public’s demand for money exceeds the supply, positive hoarding of money
takes places as individuals and businesses attempt to increase their money holdings at the
expense of others.
 Hoarding reduces the volume of loan able funds available in the financial markets.
 When the public’s demand for money is less than the supply available, negative hoarding
(also called dishoarding) occurs.
 Some individuals & businesses will dispose off their excess money holdings, increasing
the supply of loan able finds available in the financial system.
C. Creation of Credit by Banks
Banks create credit, by lending & investing excess reserve.
 In this regard, credit created by the banking system from lending excess reserves is
considered an additional source of loan able funds.
 Thus, it must be added to the amount of savings and the dishoarding of money
balances (or minus the amount of hoarding of demand) to derive the total supply of
loan able funds in the economy.
D. Foreign Lending in the Domestic Funds Market
Foreign banks & institutions also provide growing amounts of credit to borrowers domestically.
These inflowing loan able funds are particularly sensitive to the difference between domestic
credit market interest rates versus interest rates overseas.

SLF

Interest rate (%) supply of loan able funds

(Domestic savings+ money created- Hoarding demand for
money + dishoarding of money + foreign lending in the

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domestic market)

Volume of loan able funds

3. The Equilibrium Rate of Interest

The two forces of supply & demand for loan able funds determine not only the volume of
lending & borrowing going in the economy, but also the rate of interest.

DLF SLF

iE Equilibrium rate of interest;

where SLF =DLF
Interest rate

QE

Volume of Loan able Funds

The above equilibrium position is only a partial equilibrium, however.
 This is due to the fact that interest rates are also affected by other conditions in the
domestic and world economies.
Thus, a stable equilibrium interest rate will be characterized by the following four equalities:
1. Planned savings= planned investment (including both business and government
investment) across the whole economic system (i.e. Equilibrium in the Economy),
2. Money Supply = Money Demand (i.e. Equilibrium in the Money Market),
3. Quantity of loan able funds supplied = Quantity of loan able funds Demanded
(Equilibrium in the Loan able Funds Market ); and
4. The difference between "Foreign Demand for Loan able funds" and the " volume of loan
able funds supplied by foreign lenders to the Domestic Economy" = the difference
between current Exports from- and Imports in to – the Domestic Economy (i.e.
Equilibrium in the Nation’s Balance of Payments and the Foreign Currency Markets).

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To clarify the situation of partial Equilibrium in the Nation’s Balance of Payments and the
Foreign Currency Markets, consider the following example:
Assume that the foreign demand for loan able funds in the domestic funds market amounts to
Birr 1,000,000; whereas Birr 900,000 is obtained from a given foreign lending institution
during that same period. During this period, the nation has exported goods to foreign markets
the value of which amounts to Birr 1,200,000 in local currency and at the same time imported
goods from abroad the value of which amounts to Birr 1,100,000. What is the Balance of
Payment Position of the nation as well as what is the balance in the Foreign Currency
Markets? Are these markets in equilibrium position?
In order to answer the preceding two questions, let us first determine the balance (or
positions) of each of the markets; and then, compare the positions of the two markets.
Foreign Currency Market:
Foreign Demand for Loan able Funds in the Domestic Funds Market…..Birr 1,000,000
Foreign Supply of Loan able Funds to the Domestic Funds Market…………… (900,000)
Balance in the Currency Market …………………………………………(birr 100,000)
Foreign Exchange (Import/Export) market:
Gross Value of Exports (in Local Currency) ---------------------------------Birr 1,200,000
Gross Value of Imports (in Local Currency) ---------------------------------Birr 1,100,000
Balance of Payment Position --------------------------------------------------Birr 100,000
In light of the above, we can say that the two markets are at an equilibrium position.
3.1.4 The Rational Expectations Theory of Interest Rates
A. Aspects of the Rational Expectations Theory
The rational expectations theory builds up on a growing body of research evidence that the
money and capital markets are highly efficient institutions in digesting and reacting to new
information affecting interest rates & security prices.
 When new data appear about business investment, household savings, or growth in the
nation’s money supply, investors begin immediately to translate that new information in
to decisions to buy or sell securities, borrow or lend finds.
 In a short space of time –perhaps in minutes or seconds-security prices and interest rates
change to reflect the new information.

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 Old news will not affect today’s interest rates because those rates already have
impounded that information.
 In this regard, rates will only change if entirely new and unexpected information appears.
Consider the Following Example
If the federal government announces for several weeks running that it must borrow an additional
birr 1 billion next month, interest rates probably reacted to that information only the first time it
appeared;
 In fact, it probably increased at that time because investors would view the government’s
additional need for credit as adding to other demands for credit in the economy and, with
the supply of credit being unchanged, interest rates, would be expected to move higher.
 However, if the government merely repeated that same announcement again, interest
rates probably wouldn’t change a second time; it would be old information already
reflected in today’s interest-rate.
Imagine a new scenario, however.
 The government suddenly reveals that, contrary to expectations, tax revenues are now
being collected in greater amounts than first forecast and, therefore, no new borrowing
will, in fact, be needed next month.
 Interest rates probably will fall immediately as market participants are forced to revise
their borrowing and lending plants to deal with a new situation.
B. How Do We Know Direction Rates Will Move?
Clearly, the path raters will take depends on what market participants expected to begin with.
 Ife market participants were expecting increased demand for credit (with supply
unchanged), an unexpected announcement of reduced credit demand implies lower
interest rates in the future.
 Similarly, a market expectation of less credit demand in the future (again, supply
unchanged), when confronted with an unexpected announcement of higher credit
demand, implies that interest rates will rise.
The rational expectations view, then, argues that forecasting interest rate changes requires
knowledge of the public’s current set of expectations.
 If new information is sufficient to alter those expectations, interest rates must change.

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 This portion of the rational expectations theory creates significant problems for
government policy makers.
- It implies that policy makers can not cause interest rates to move in any particular
direction without knowing what the public already expects to happen.
 Indeed, unless the government officials can convince the public that a new set of
expectations is warranted, policy makers cannot change interest rates at all.
Because guessing " with the public’s expectations are" is treacherous at best (i.e. untrue),
rational expectations theorists suggest that rate hedging using various tools (such as financial
futures) to reduce the risk of loss from changing interest rates is preferable to rate forecasting.

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