Financial Markets and Institutions

PowerPoint Slides for: Financial Markets and Institutions By Jeff Madura Prepared by David R. Durst The University of Akron

Determination of Interest Rates 2

Chapter Objectives • Explain Loanable Funds Theory of Interest Rate Determination • Identify Major Factors Affecting the Level of Interest Rates • Explain How to Forecast Interest Rates

Relevance of Interest Rate Movements • Changes in interest rates impact the real economy • Investment spending • Interest sensitive consumer spending such as housing • Interest rate changes affect the values of all securities • Security prices vary inversely with interest rates • Varying interest rates impact retirement funds and retirement income • Interest rates changes impact the value of financial institutions • Managers of financial institutions closely monitor rates • Interest rate risk is a major risk impacting financial institutions

Loanable Funds Theory of Interest Rate Determination • Theory of how the general level of interest rates are determined • Explains how economic and other factors influence interest rate changes • Interest rates determined by demand and supply for loanable funds

Loanable Funds Theory, cont. • Demand = borrowers, issuers of securities, deficit spending unit • Supply = lenders, financial investors, buyers of securities, surplus spending unit • Assume economy divided into sectors • Slope of demand/supply curves related to elasticity or sensitivity of interest rates

Sectors of the Economy • Household Sector--Usually a net supplier of loanable funds • Business Sector—Usually a net demander in growth periods • Government Sectors • States—Borrow for capital projects • Federal—Borrow for capital projects and deficit spending • Foreign Sectors—Net supplier since early 1980’s

Demand for Loanable Funds • Sum of sector demand (quantity) at varying levels of interest rates • Sector cash receipts in period lessthan outlays = borrower • Quantity demanded inversely related to interest rates • Variables other than interest rate changes cause shift in demand curve

Demand for Loanable Funds Interest Rate Quantity of Loanable Funds

Loanable Funds Theory • Households demand loanable funds to finance housing, automobiles, household items • These purchases result in installment debt. Installment debt increases with the level of income • There is an inverse relationship between the interest rate and the quantity of loanable funds demanded Household Demand for Loanable Funds

Loanable Funds Theory • 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 project’s Net Present Value • Select all projects with +NPV’s Business Demand for Loanable Funds

n CFt  –INV + NPV = (1 + k)t t = 1 Loanable Funds Theory Net Present Value is calculated as follows: Business Demand for Loanable Funds

Loanable Funds Theory • Projects with a positive NPV are accepted because the present value of their benefits outweighs their costs • If interest rates decrease, more projects will have a positive NPV • Businesses will need a greater amount of financing • Businesses will demand more loanable funds Business Demand for Loanable Funds

Loanable Funds Theory • There is an inverse relationship between interest rates and the quantity of loanable funds demanded • The curve can shift in response to events that affect business borrowing preferences • Example: Economic conditions become more favorable • Expected cash flows will increase > more positive NPV projects > increased demand for loanable funds Business Demand for Loanable Funds

Loanable Funds Theory • When planned expenditures exceed revenues from taxes, the government demands loanable funds • Municipal (state and local) governments issue municipal bonds • Federal government and its agencies issue Treasury securities and federal agency securities. Government Demand for Loanable Funds

Loanable Funds Theory • Federal government expenditure and tax policies are independent of interest rates • Government demand for funds is interest-inelastic Government Demand for Loanable Funds Interest Rate D Quantity of Loanable Funds

Loanable Funds Theory • A foreign country’s demand for U.S. funds is influenced by the differential between its interest rates and U.S. rates • The quantity of U.S. loanable funds demanded by foreign investors will be inversely related to U.S. interest rates Foreign Demand for Loanable Funds

Loanable Funds Theory • The aggregate demand for loanable funds is the sum of the quantities demanded by the separate sectors • The aggregate demand for loanable funds is inversely related to interest rates Aggregate Demand for Loanable Funds

Sector Supply of Loanable Funds • Households are major suppliers of loanable funds • Businesses and governments may invest (loan) funds temporarily • Foreign sector a net supplier of funds in last twenty years • Federal Reserve’s monetary policy impacts supply of loanable funds

Supply of Loanable Funds • Sum of sector supply (quantity) at varying levels of interest rates • Sector cash receipts in period greaterthan outlays—lender • Quantity supplied directly related to interest rates • Variables other than interest rate changes causes a shift in the supply curve

S Interest Rate Quantity of Loanable Funds

Loanable Funds Theory • Equilibrium Interest Rate • Aggregate Demand DA = Dh + Db + Dg + Dm + Df • Aggregate Supply SA = Sh + Sb + Sg + Sm + Sf In equilibrium, DA = SA

Supply of Loanable Funds Demand for Loanable Funds Graphic Presentation Interest Rates Quantity of Loanable Funds

Loanable Funds Theory • Graphic Presentation • When a disequilibrium situation exists, market forces should cause an adjustment in interest rates until equilibrium is achieved • Example: interest rate above equilibrium • Surplus of loanable funds • Rate falls • Quantity supplied reduced, quantity demanded increases until equilibrium

General Equilibrium Interest Rate • Means of explaining how economic factors affect interest rate levels • Interest rate level where quantity of aggregate loanable funds demanded = supply • Surplus and shortage conditions • Surplus- Quantity demanded < quantity supplied followed by market interest rate decreases • ShortageGovernment interest rate ceilings below market interest rates

Interest Rate Changes • + Directly related to level of economic activity or growth rate of economic activity • + Directly related to expected inflation • – Inversely related to rates of money supply changes

Economic Forces That Affect Interest Rates • Economic Growth • Expected impact is an outward shift in the demand schedule without obvious shift in supply • New technological applications with +NPV’s • Result is an increase in the equilibrium interest rate

i = E ( I ) + i n r Economic Forces That Affect Interest Rates: The Fisher Effect • Lenders want to be compensated for expected loss of purchasing power (inflation) when they lend • Nominal Interest Rates = Sum of real rate plus expected rate of inflation, • Expected Real Rate (ex ante) = expected increase in purchasing power in period • Realized Real Rate (ex post) = nominal rates less actual rate of inflation in period

Economic Forces That Affect Interest Rates • Inflation • The Fisher Effect • Nominal Interest Rates = Sum of Real Rate plus Expected Rate of Inflation in = ir + E(I)

2 0 A n n u a l i z e d R e a l I n t e r e s t R a t e 1 5 A n n u a l i z e d I n f l a t i o n A n n u a l i z e d T - B i l l 1 0 R a t e 5 0 - 5 1 9 8 0 1 9 8 1 1 9 8 2 1 9 8 3 1 9 8 4 1 9 8 5 1 9 8 6 1 9 8 7 1 9 8 8 1 9 8 9 1 9 9 0 1 9 9 1 1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 9 6 1 9 9 7 1 9 9 8 1 9 9 9 Y e a r Figure 2.12 here

Economic Forces That Affect Interest Rates • 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 Affect Interest Rates • Money Supply • When the Fed increases the money supply, it increases supply of loanable funds • Places downward pressure on interest rates

Economic Forces That Affect Interest Rates • Federal Government Budget Deficit • Increase in deficit increases the quantity of loanable funds demanded • Demand schedule shifts outward, raising rates • Government is willing to pay whatever is necessary to borrow funds, “crowding out” the private sector

Economic Forces That Affect Interest Rates • 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 the world

Forecasting Interest Rates • Attempts to forecast demand/supply shifts • Forecast economic sector activity and impact upon demand/supply of loanable funds • Forecast incremental effects on interest rates • Forecasting interest rates has been difficult

Summary: Key Factors Impacting Interest Rates Over Time • Economic Growth—Increased growth; increased demand for funds; interest rates increase • Expected inflation--security prices fall; interest rates increase • Government budgets • Deficit—increase borrowing; security prices fall, interest rates increase • Surplus—decreased borrowing; security prices increase; interest rates decrease • Increased foreign supply of loanable funds—security prices increase; interest rates decrease

Financial Markets and Institutions