Determinants of interest

rate
 Borrowing and lending in the financial market
depend to a significant extent on the rate of
interest. In economics interest is a payment for
the services of capital. It represents a return on
capital.
 Interest is the price of hiring capital. Capital,
as a factor of production, takes the form of
machinery, equipment or any other physical
assets used in production of goods.
 On the other hand, funds must be made
available to the entrepreneurs for buying these
physical assets. Purchase of capital assets is
called investment and funds made available for
the purchase of such capital assets is called
financial capital. Some persons have to supply
this financial capital to the entrepreneurs who
would use it for investment in real capital
assets.
 Market rate of interest
 The payment to those who supply financial
capital for its use is called the market rate of
interest. This is expressed as a percentage of
sum of funds borrowed.
 Return on capital

 The entrepreneur who buys capital equipment

and uses it in the process of production gets
addition to his revenue, which is called return
on capital. The return on capital is the
addition to production which increases his
revenue
 The interest rate is determined by demand and
supply: the demand for present control of
resources by those who do not have it, and the
supply from those who do have control and are
willing to surrender it for a price.
 PURE INTEREST AND GROSS
INTEREST RATES
 According to Prof. Meyers, interest is the price
paid for the use of loan able funds. Different
rates of interest are charged for the same sum
of loan for the same period because of the fact
that some loans involve more risk, more
inconvenience and more incidental work.
 Types of interest rate
 Pure interest rate
 Gross interest rate
 The pure interest is the payment for the use
of money as capital when there is neither
inconvenience risk nor any other management
problem.
 Gross interest is the gross payment which the
lender gets from the borrower. It includes not
only net interest but also payment for other
elements, which have been outlined below.
 Elements of Gross interest
 Payment for risk : Every loan, if not secured
fully, involves risk of non- payment due to the
inability or unwillingness of the borrower to
pay back the debt. The lender charges
something extra for taking such risk.
 Payment for inconvenience : The moneylender may
add extra charges for the inconvenience caused to
him. The greater the inconvenience involved, the
higher will be such charge and consequently the gross
interest. For instance,the borrower may repay at a
very inconvenient time to the lender or the borrower
may invest the capital for a period longer than the one
for which loan has been given.
 Payment for management : The lender
expects to be compensated for the additional
work he has to do in connection with lending
e.g., the form of keeping accounts, sending
notices and reminders and other incidental
work.
 Payment for exclusive use of money, i.e.
pure interest:
 It is the payment for the use of money which is
in addition to payments for the above-
mentioned risks, inconvenience and
management.
 Real interest rate
 Alternative term for real rate of interest
 nominal interest rate
 Definition
 Market interest rate unadjusted to reflect the
erosion of the purchasing power due to
inflation .
 A nominal variable, such as a nominal interest
rate, is one where the effects of inflation have
not been accounted for. Changes in the
nominal interest rate often move with changes
in the inflation rate.
 Real interest rates are interest rates where
inflation has been accounted for.
Theory of term structure of interest
rates
Changes in the level of interest rate, which arise
due to changes in the rate of inflation, unusual
risk premiums, changing credit conditions,
there are changes, which are termed as the
'term structure of interest rate'
 Yield curve
 Relationship between yields and maturities of
bonds in given default risk classes. The
relationship is usually presented graphically as
Yield Curve'.
The yield curve changes a little everyday and
there are different yield curves for each class
of bonds. The yield curve for the riskier
classes of bonds are at a higher level than the
yield curve for less risky bonds. The difference
in levels is due to the difference in risk
premium.
 The Liquidity Preference Theory
 According to Liquidity Preference Theory,
lenders prefer short-term securities over long
term securities, unless the yield on the longer-
term securities are high enough to compensate
for the greater interest rate risk.
 Expectations Theory
 The Expectation theory hypothesizes that
investors‘ expectation alone shape the yield
curve.
Its validity rests on the assumption that investors
are indifferent to any variation in risks
associated with different maturities.
 Market Segmentation Theory
 According to market segmentation theory,
interest rates for various maturities are
determined by demand and supply conditions
in the relevant segments of the market.
 The interest rates are generally referred to as spot and
forward rates:-
 Forward rate refers to yield to maturity for bond
which is expected to exist in future:
 Spot rate:- refers to the interest rate for bond, which
currently exists and is being currently bought and
sold.
 Forward rates are implicit. These rates cannot be
observed, whereas, spot rates can be observed.
 The segmentation theory holds that financial
markets are divided into different maturity
wise segments, and the rate of interest in each
of this segments is determined by its supply of
and demand for funds.
Determinants of general structure of
interest rates
 Default risk: it refers to the possibility of an
adverse outcome to an event. All financial
assets, except governments securities are
subject to some degree of default risk although
they differ in their degree of risk.
 Marketability or liquidity:
 The financial assets differ in their
marketability or liquidity that is they differ in
respect of the possibility that a significant
amount of security can be sold relatively
quickly without price concessions.
 Tax status: tax features cause difference on
similar financial assets or claims.
 FACTORS AFFECTING MARKET
INTEREST RATES
Economic Conditions
 Interest rates have a tendency to move up and down

with changes in the volume of business activities. In

period of rapid economic growth, business firms
require large amount of capital to finance increased
requirements of working capital and fixed asset.
 The business demand for borrowed funds, combined

with increase in consumer borrowing put upward

pressure on interest rates.
 Monetary Policy
Monetary policy refers to the policy measures adopted by
the Central Bank of the country such as changes in rate of
interest (i.e, change in cost of credit) and the availability of
credit. The policy regarding the growth of money supply
also comes under the purview of monetary policy. Changes
in bank rate, open market operations, cash reserve ratio of
banks, selective credit controls are the various instruments
of monetary policy.
 Bank Rate
Bank rate is the rate at which the central bank
of a country provides loans to the commercial
banks. Bank rate is also called the discount
rate because in the earlier days, the central
bank used to provide finance to the
commercial banks by rediscounting their bills
of exchange.
 Measures of money supply
 The total supply of money in circulation in a given country's
economy at a given time. There are several measures for the
money supply, such as M1, M2, and M3.

 The money supply is considered an important instrument for

controlling inflation by those economist who say that growth
in money supply will only lead to inflation if money demand
is stable
 In order to control the money supply, regulators have to decide
which particular measure of the money supply to target .

 The broader the targeted measure, the more difficult it will be

to control that particular target. However, targeting an
unsuitable narrow money supply measure may lead to a
situation where the total money supply in the country is not
adequately controlled.
 M1
 One measure of the money supply that
includes all coins currency held by the public
travelers cheque , checking account balances
,New account , atomic transfers service
accounts, and balances in credit unions.
 M3
 One measure of the money supply that
includes M2, plus large time deposits , repos
of maturity greater than one day at commercial
banks , and institutional money market
institutions .
 M2
One measure of the money supply that
includes M1plus savings and small time
deposits overnight repos at commercial banks ,
and non-institutional money market accounts .
A key economic indicator used to forecast
inflation.
 M1 consists of the most highly liquid assets.
That is, M1 includes all forms of assets that
are easily exchangeable as payment for goods
and services. It consists of coin and currency
in circulation, traveler's checks, demand
deposits, and other checkable deposits
 M2 is a broader measure of money than M1. It
includes all of M1, the most liquid assets, and
a collection of additional assets that are
slightly less liquid. These additional assets
include savings accounts, money market
deposit accounts, small time deposits (less
than $100,000) (these would include
certificates of deposits) and retail money
market mutual funds.
 M3 is an even broader definition of the money
supply, including M2 and other assets even
less liquid than M2. As the number gets larger,
1 … 2 … 3, the assets included become less
and less liquid.