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Financial Markets and Institutions: Chapter 2

Chapter 2 Determination of Interest Rates: apply the loanable funds theory to explain why interest rates change, identify the most relevant factors that affect interest rate movements, explain how to forecast interest rates. | 1 1 2 ■ apply the loanable funds theory to explain why interest rates change ■ identify the most relevant factors that affect interest rate movements ■ explain how to forecast interest rates 2 Chapter Objectives 2 Determination of Interest Rates 2 Loanable Funds Theory The Loanable Funds Theory suggests that the market interest rate is determined by the factors that control supply of and demand for loanable funds. Can be used to explain: Movements in the general level of interest rates in a particular country Why interest rates among debt securities of a given country vary. 3 Demand for Loanable Funds Household demand for loanable funds Households demand loanable funds to finance housing expenditures as well as the purchase of automobiles and household items. Inverse relationship between the interest rate and the quantity of loanable funds demanded. (Exhibit 2.1) 4 Demand for Loanable Funds Business demand for loanable funds Depends on number of business projects to be implemented. More demand at lower interest rates. (Exhibit 2.2) 5 Demand for Loanable Funds Government demand for loanable funds Governments demand loanable funds when planned expenditures are not covered by incoming revenues. Government demand is said to be interest inelastic: insensitive to interest rates. Expenditures and tax policies are independent of the level of interest rates. (Exhibit 2.3) 6 Exhibit 2.1 Relationship between Interest Rates and Household Demand (Dh) for Loanable Funds at a Given Point in Time 7 Exhibit 2.2 Relationship between Interest Rates and Business Demand (Db) for Loanable Funds at a Given Point in Time 8 Exhibit 2.3 Impact of Increased Government Deficit on the Government Demand for Loanable Funds 9 Demand for Loanable Funds Foreign demand for loanable funds A country’s demand for foreign funds depends on the interest rate differential between the two. The greater the differential, the greater the demand for foreign funds. The quantity of U.S. loanable funds demanded by | 1 1 2 ■ apply the loanable funds theory to explain why interest rates change ■ identify the most relevant factors that affect interest rate movements ■ explain how to forecast interest rates 2 Chapter Objectives 2 Determination of Interest Rates 2 Loanable Funds Theory The Loanable Funds Theory suggests that the market interest rate is determined by the factors that control supply of and demand for loanable funds. Can be used to explain: Movements in the general level of interest rates in a particular country Why interest rates among debt securities of a given country vary. 3 Demand for Loanable Funds Household demand for loanable funds Households demand loanable funds to finance housing expenditures as well as the purchase of automobiles and household items. Inverse relationship between the interest rate and the quantity of loanable funds demanded. (Exhibit 2.1) 4 Demand for Loanable Funds Business demand for loanable funds Depends on number of business projects to be implemented. .