The Determinants of Interest Rates

The Determinants of Interest Rates:
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. 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.
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 publics demand for money. The interest rate serves as an important tool for government policy through its influence on the volume of savings and investment. 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.
The Classical Theory of Interest Rates

The classical theory argues that the rate of interest is determined by two forces: I. the supply of savings, derived mainly from households, and II. the demand for investment capital, coming mainly from the business sector.
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. 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). 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 projects 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. 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 =
NCF n NCF1 NCF 2 ... 1 2 investment analysis rthe net present value (NPV) approach. 1 is n Another method of1 r 1 r
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. In addition to the business sector, both consumers and governments are also important borrowers today.
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). 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. Speculative Demand for Money or Cash Balances
The Total Demand for Money or Cash Balances And the Equilibrium Rate of Interest
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. 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. 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
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.
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. 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. 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 Interest rates will be stable only when the economy, money market, loanable funds market, and foreign currency markets are simultaneously in equilibrium.
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. The public forms rational and unbiased expectations about the future demand and supply of credit, and hence interest rates. 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 periods 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 publics current set of expectations. 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.

The Determinants of Interest Rates

Uploaded by

Copyright:

Available Formats

The Determinants of Interest Rates

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

The Determinants of Interest Rates

Uploaded by

Copyright:

Available Formats

The Determinants of Interest Rates:

Functions of the Interest Rate in the Economy

The Classical Theory of Interest Rates

The Liquidity Preference (Cash Balances) Theory of Interest Rates

The Loanable Funds Theory of Interest

The Rational Expectations Theory of Interest

You might also like