CHAPTER 5

Interest Rate Determination

Interest Rates (Yield)

The price paid for borrowing funds, expressed as a percent per year. or The price received for lending of funds, expressed as a percent per year.

(skip Fisher Hypothesis)

Thomson/South-Western 2006

Interest Rates (Yield)

! Interest rates are important because they affect: ! the level of consumer expenditures on durable goods; ! investment expenditures on plant, equipment, & technology; ! Borrowing and lending decision ! the monthly payments on mortgages ! Price of financial instruments
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Real and Nominal Interest Rates

! The nominal interest rate is the stated or actual interest rate, unadjusted for inflation. ! The real interest rate is the nominal interest rate adjusted for inflation. ! The real interest rate is the actual interest rate that would prevail in a hypothetical world of zero inflation.
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Individual Sources of Supply and Demand for Loanable Funds in the United States ! Sources of Supply ! personal saving ! business saving ! government budget surplus ! foreign lending in the U.S.

Individual Sources of Supply and Demand for Loanable Funds in the United States

! Sources of Demand ! household credit purchases ! business investment spending ! government budget deficit ! foreign borrowing in the U.S.

The Loanable Funds Model

! The interest rate is the price paid for the right to borrow & use loanable funds. (interest rate is price of loanable funds) ! Borrowers = demand ! Savers = supply
If demand for loan increases (demand curve shifts right), interest rate (price of loan) increases. ! 7

The Loanable Funds Model

! The interest rate is the price paid for the right to borrow & use loanable funds. ! Borrowers = demand ! Savers = supply

If supply of loan increases (supply curve shifts right), interest rate (price of loan) decreases. ! 8

Factors Shifting Supply & Demand ! Inflation Expectations ! Federal Reserve Policy ! The Business Cycle ! Federal Budget Deficits (Surpluses)
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Inflation Expectations
! Interest rates rise in periods during which people expect inflation to increase. ! Interest rates typically fall when people expect inflation to decline. ! Nominal Interest rate = Real Interest rate + Inflation Fisher Effect
inflation value of money decreases burden of debt is reduced by higher price

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Inflation Expectations
! Nominal Interest rate = Real Interest rate + Inflation Fisher Effect
! People are less willing to lend because they expect the real value of the principal to decline supply shifts left ! People are much more willing to borrow (rather spend now than later) demand shifts right

Higher Inflation Expectation

S1LF

i 1E

! Inflation Expectation effects long term interest rates

D1LF

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Federal Reserve Policy

! To stimulate the economy, the Fed ! encourage banks to expand loans, ! boosting the money supply supply curve shifts right interest rate ! To restrain economic activity, the Fed ! force banks to reduce their lending, ! limiting the money supply supply curve shifts left interest rates ! The Fed has more direct influence on short-term interest
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Ease Monetary Policy

S1LF

Q1E 14

Tight Monetary Policy

The Business Cycle

! Interest rates have been strongly pro-cyclical:
! rising during the expansion ! falling during the contraction ! This pattern is most evident in short-term interest rates.

S1LF

i 1E

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The Business Cycle

! During expansion phase:
! Demand for funds (consumption, investment) ! Demand for products Inflation (price ) ! Fed tries to slow down the growth: tighten monetary policy (supply ) ! Demand curve shift to the right, supply curve shift to the left ! Interest rates go up
i 1E

Business Expansion

S1LF

D1LF

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The Business Cycle

! During recession phase:
! Demand for funds (consumption, investment) ! Demand for products Inflation ! Fed tries to boost up the growth: ease monetary policy ! Demand curve shift to the left, supply curve shift to the right ! Interest rates go down

Business Recession

S1LF

i 1E D1LF

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Federal Budget Deficits (or Surpluses)

! Intuitively, an increase in the federal budget deficit should raise interest rates.
! An increase in borrowing by the federal government implies a rightward shift in the demand curve for loanable funds.

Federal Budget Deficits (or Surpluses)

! Gov borrowing demand shifts right interest ! Gov spending inflation interest rate (Fisher Effect) ! This pattern is most evident in long-term interest rates.

! Most economists agree that deficits lead to higher interest rates.

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Government Budget Deficit

Examples of events shifting supply curve ! personal saving resulting from demographic changes or thriftiness ! business saving ! Federal money supply ! politic and economic stability in other countries ! the lending standard from banks

i 1E

D1LF

Q1E

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Examples of events shifting demand curve ! business and consumer confidence ! interest rate in the other countries ! business profits

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