Chapter 5

The Determinants of Interest Rates: Competing

Ideas

5 - 2

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Learning Objectives

• To understand the important roles that interest rates play within the economy.

• To explore the most important ideas about what determines the level of interest rates and asset prices within the financial system.

• To identify the key forces that economists believe set market interest rates and asset prices into motion.

5 - 3

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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.

5 - 4

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Introduction

• Some authorities refer to the rate of interest as the price of credit.

• Interest rates send price signals to borrowers, lender, savers, and investors.

• Whether higher interest rates increase or decrease savings and investment depends on the relative strength of its effect on supply and demand factors.

5 - 5

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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 allocates the available supply of credit, generally providing loanable funds to those investment projects with the highest expected returns.

• It brings the supply of money into balance with the public’s demand for money.

5 - 6

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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.

5 - 7

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Functions of the Interest Rate in the Economy

• To help uncover these rate-determining forces, we assume that there is one fundamental interest rate, known as the pure or risk-free rate of interest, which is a component of all interest rates.

• The closest real-world approximation to this pure rate of return is the market interest rate on government bonds.

5 - 8

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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.

5 - 9

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Classical Theory of Interest Rates

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.

5 - 10

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Classical Theory of Interest Rates

The Substitution EffectRelating Savings and Interest Rates

InterestRate

CurrentSaving

r1

S1

r2

S2

5 - 11

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Classical Theory of Interest Rates

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).

5 - 12

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Classical Theory of Interest Rates

The Demand for Investment Funds• Gross business investment equals the sum of replacement

investment and net investment.• One investment decision-making method 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.

5 - 13

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Classical Theory of Interest Rates

• The internal rate of return (r) equates the total cost of an investment project with the future net cash flows (NCF) expected from that project discounted back to their present values.

• Cost of project =

The Demand for Investment Funds … continued

nn

rrr

1

NCF...

1

NCF

1

NCF2

21

1

• Another method of investment analysis is the net present value (NPV) approach.

5 - 14

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Classical Theory of Interest Rates

The Cost of Capital and the Business Investment Decision

A15%

B12% C

10% D8%

E7%

Dollar Cost of Investment Projects

Expected Internal Rates of

Return on Alternative Investment

Projects

Cost of Capital Funds = 10%

C10% D

8%E

7%

– acceptable

– acceptable

– indifferent

unprofitableunprofitable

5 - 15

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Classical Theory of Interest Rates

The Investment Demand ScheduleIn the Classical Theory of Interest Rates

r2

InterestRate

InvestmentSpending

r1

I1I2

5 - 16

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Classical Theory of Interest Rates

The Equilibrium Rate of Interest In the Classical Theory

InterestRate

Savings &Investment

rE

QE

Investment Savings

5 - 17

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Classical Theory of Interest Rates

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.

5 - 18

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Classical Theory of Interest Rates

• In addition to the business sector, both consumers and governments are also important borrowers today.

Limitations … continued

5 - 19

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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).

5 - 20

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Liquidity Preference (Cash Balances) Theory of Interest Rates

• 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.

5 - 21

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Speculative Demand for Money or Cash Balances

5 - 22

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Total Demand for Money or Cash BalancesAnd the Equilibrium Rate of Interest

5 - 23

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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.

5 - 24

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Liquidity Preference (Cash Balances) Theory of Interest Rates

The Equilibrium Interest RateIn the Liquidity Preference Theory

InterestRate

Quantity ofMoney / Cash

Balances

Equilibrium interest rate Total

Demand

QE

MoneySupply

5 - 25

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Liquidity Preference (Cash Balances) Theory of Interest Rates

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.

5 - 26

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

5 - 27

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Loanable Funds Theory of Interest

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.

5 - 28

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Loanable Funds Theory of Interest

Total Demand for Loanable Funds (Credit)

InterestRate

Amount ofLoanable Funds

Total Demand = Dconsumer + Dbusiness + Dgovernment + Dforeign

5 - 29

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Loanable Funds Theory of Interest

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.

5 - 30

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

5 - 31

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Loanable Funds Theory of Interest

Total Supply of Loanable Funds (Credit)

InterestRate

Amount ofLoanable Funds

Total Supply = domestic savings +

newly created money + foreign lending – hoarding demand

5 - 32

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Loanable Funds Theory of Interest

The Equilibrium Interest Rate

InterestRate

Amount ofLoanable Funds

rE

QE

Demand

Supply

5 - 33

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Loanable Funds Theory of Interest

• At equilibrium: Planned savings = planned investment across the whole

economic system Money supply = money demand Supply of loanable funds = demand for loanable funds Net foreign demand for loanable funds = net exports

5 - 34

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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.

5 - 35

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Changes in the Demand for and Supply ofLoanable Funds

5 - 36

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Changes in the Demand for and Supply ofLoanable Funds

5 - 37

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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.

5 - 38

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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.

InterestRate

Amount ofLoanable Funds

rE

QE

Expected Demand

Expected Supply

5 - 39

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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.

5 - 40

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Expected Demand for and Supply of Loanable Funds

5 - 41

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Rational Expectations Theory of Interest

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.

5 - 42

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Markets on the Net

• Bank Rate.com at www.bankrate.com• Bond Market Association at www.investinginbonds.com• CNN/Money at www.cnnfn.com• European Central Bank at www.ecb.int/• Federal Reserve System at www.federalreserve.gov• National Endowment for Financial Education at www.nefe.org

5 - 43

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Chapter Review

• Introduction: Interest Rates and the Price of Credit• Functions of the Interest Rate in the Economy• The Classical Theory of Interest Rates

- Savings by Households, Business Firms and Governments- The Demand for Investment Funds- The Equilibrium Interest Rate- Limitations of the Classical Theory

5 - 44

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Chapter Review

• The Liquidity Preference or Cash Balances Theory of Interest Rates- The Demand for Liquidity- The Supply of Money (Cash Balances)- The Equilibrium Interest Rate- Limitations of the Liquidity Preference Theory

5 - 45

McGraw-Hill/IrwinMoney and Capital Markets, 9/e

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Chapter Review

• The Loanable Funds Theory of Interest- The Demand for Loanable Funds- The Supply of Loanable Funds- The Equilibrium Interest Rate

• The Rational Expectations Theory of Interest