Determinants of Interest Rates

Interest rate simply is the cost of borrowing money. Otherwise,, it is the reward for lending
money.

Changes in interest rates influence the performance and decision making for individual
investors, businesses, and governmental units alike
alike.

Example:
For example, when the Federal Reserve unexpectedly increased interest rates in February 2010,
financial markets reacted significantly: the Dow Jones Industrial Average declined 0.9 percent in
value, the yield on Treasuryy securities increased (i.e., the yield on two
two-year
year T-notes
T increased
from 0.88 percent to 0.92 percent), gold prices dropped $11 to $1,112.70, and the U.S. dollar
weakened against foreign currencies (the dollar fell from $1.3613/
$1.3613/€€ to $1.3518/€).

Note:
Treasury bills have maturities of a year or less.
Treasury notes are issued with maturities from two to ten years.
Treasury bonds are long-termterm investments that have maturities of 10 to 30 years from
their issue date.
The minimum denomination for all three is $1,000.
You
ou don’t have to hold any of these securities (bills, notes, or bonds) till maturity. You
can, in fact, cash out at any point. The longer until the maturity of the bond, however, the
more its price can fluctuate and, therefore, the more you ri
risk
sk losing money.

Given the impact a change in interest rates has on security values, financial institution and other
firm managers spend much time and effort trying to identify factors that determine the level of
interest rates at any moment in time, as w
well
ell as what causes interest rate movements over time.

One model that is commonly used to explain interest rates and interest rate
movements is the Loanable Funds Theory.
Lonable Funds Theory:
A theory of interest rate determination that views equilibrium interest rates in financial markets
as a result of the intersection of the demand for and supply of loanable funds.

The aggregate quantity of supplied funds is positively related to the interest rate.
The aggregate quantity of demanded funds is inversely related to the interest rate.
The equilibrium point is the intersection between both curves.

Interest rates Types:

Nominal Interest Rate: The interest rates actually observed in the financial markets.
Real interest Rate: The interest rate that would exist on the security if no inflation were
expected.
It measures the society's relative time preference for consuming today rather than tomorrow.
Inflation: The continual increase in the price level of a basket of goods and services.

Fisher Effect:
The relation between both nominal and real interest rates and the inflation rate.
Accordingly,
= + ∆

= − ∆