2. 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 refer
to this as the price of credit.
3. Introduction
The rate of interest is a ratio of the
money cost of borrowing divided by the
money actually borrowed.
Interest rates send price signals to
borrowers, lenders, 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.
4. Functions of the Interest Rate
in the Economy
Rate of Interest
Helps guarantee that current savings flow into
investment to promote economic growth
Generally allocates the available supply of
credit to investment projects with the highest
expected returns
Balances the supply of money with the
public’s demand for money
Tool of government policy through its
influence on the volume of saving and
investment.
5. The Interest Rate
Common reference to “the interest rate”
Multiple rates in economy
Even securities by the same borrower can
have differing rates
Focus on forces that impact all rates
Assume a single fundamental rate
Pure or Risk-free rate of interest
Opportunity cost of holding idle cash
Closest real-world equivalent is government
bonds rate
6. The Classical Theory of Interest Rates
The classical theory is one of the oldest
interest rate theories.
Determinants of pure or risk-free interest
rate.
Long term.
Developed during 18th and 19th century by
a number of British Economists.
Elaborated by British Economist Irving
Fisher (1930)
7. The Classical Theory of Interest Rates
Rate of interest is determined by the
balance of two forces
1. Supply of savings, derived mainly from
households
2. Demand for investment capital, coming
mainly from the business sector
8. Savings by Household
Most savings in modern industrialized
economies is carried out by Individuals and
Families.
Current household savings is
Abstinence from consumption spending
Difference between current income and
current consumption expenditures
9. In making the decision on the timing and
amount of savings to be done. House-holds
typically consider several factors:
1. the size of current and expected long-term
income
2. the desired savings target. and
3. the desired proportion of income to be set
aside in the form of savings (.i.e.. the
propensity to save)
Generally volume of HH savings rises with
income.
10. Although income level dominate savings
decisions, Interest rate also play an
important role.
It affect an individual’s choice between
current consumption and saving for future
consumption.
11. Classical Theory assumes that Individuals
have a time preference for current
consumption
Prefer current enjoyment of goods and
services over future enjoyment
the only way to encourage an individual or
family to consume less now and save more
is to offer a higher rate of interest on
current savings.
12. When interest rates rises, people tend to save
more reducing their consumption & vice versa.
Payment of interest is a reward for waiting- the
postponement of current consumption in favor of
greater future consumption
Higher rates encourage the substitution of current
saving for current consumption.
This substitution effect calls for a positive
relationship between interest rate and volume of
savings.
14. Savings by Business Firms
Businesses also save and direct a portion of
their savings into the financial markets to
purchase securities and make loans.
Most businesses hold savings balances in the
form of retained earnings.
The volume of business saving depends on two
key factors:
the level of business profits and
the dividend policies of corporations.
5-14
15. Dividend policies of major corporations do
not change very often.
So, the critical clement in determining the
amount of business savings is the level of
business profits.
If profits are expected to rise, businesses
will be able to draw more heavily on
earnings retained in the firm and less
heavily on the money and capital market
for funds
16. It result in reduction in the demand for
credit and a tendency toward lower interest
rate.
On the other hand, when profits fall but
firms do not cut back on their investment
plans, they are forced to rely on money and
capital market for investment funds.
The demand for credit rises, and interest
rates rises as well.
17. Although the principal determinant of business
saving is profits, interest rate also play a major
role in the decision of what proportion of current
operating costs and long -term investment
expenditures should be financed internally and
what proportion externally.
Higher interest rates in the money and
capital market encourage firms to use
internally generated funds more heavily in
financing projects.
18. Government Savings
When the government has a budget
surplus
Major determinants
Income flows in the economy
Pacing of government spending.
Interest Rate are not a key factor.
19. Demand for investment funds
Primarily for businesses
Businesses require huge amounts of funds
each year to purchase equipment, machinery
and inventories and to support the
construction of new buildings and other
physical facilities
Gross business investment equals the
sum of replacement investment and net
investment
20. Replacement investments are more
predictible
Grows at a more even rate than net
investment.
Financed exclusively from inside the firm
and follows a routine pattern based on
depreciation formula.
21. Net investment depends on
Business community’s outlook for future
sales.
Changes in technology
Industrial Capacity
Cost of raising fund.
Those factors are subject to frequent
change, so net investment is volatile.
22. Net investment because of its size and
volatility, is a driving force in the economy.
Changes in net investment are closely
linked to fluctuations in the nation’s
output of goods and services, employment,
and prices.
A significant decline in net investment
frequently leads to a business recession, a
decline in productivity, and a rise in
unemployment and vice versa
23. The Investment Decision Making Process
Complex and depends on host of qualitative and
quantitative factors
Different methods are followed for financial
viability including NPV, IRR, PI etc.
One investment decision-making method involves
the calculation of a project’s 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
24. The firm usually compares each project’s
expected internal return with the cost of
raising capital (i.e. interest rate) in the
money and capital markets to finance the
project.
As credit becomes scarcer and more
expensive, the cost of borrowed capital
rises, eliminating some investment
projects from consideration.
25. 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 =
n
n
r
NCF
...
r
NCF
r
NCF
1
1
1
2
2
1
1
Another method of investment analysis is the
net present value (NPV) approach.
26. The Cost of Capital and
the Business Investment Decision
A
15%
B
12% C
10% D
8%
E
7%
Dollar Cost of Investment Projects
Expected
Internal
Rates of
Return on
Alternative
Investment
Projects
Cost of
Capital
Funds
= 10%
C
10% D
8%
E
7%
– acceptable
– acceptable
– indifferent
unprofitable
unprofitable
27. The Investment Demand Schedule
In the Classical Theory of Interest Rates
r2
Interest
Rate
Investment
Spending
r1
I1
I2
28. The Equilibrium Rate of
Interest In the Classical Theory
Rate of
interest
(% per
annum)
Volume of savings & investment ($billions)
rE
QE = $200 billion
Demand for
Investment
Volume
of Savings
E
S
S
D
D
29. Limitations
Ignores factors other than savings and
investment that affect interest rates
For example, many financial institutions
can “create” money today by making
loans
Repaying the loan “destroys” money
30. Income and wealth are more
important than interest rates in
determining savings
Traditionally businesses primary
borrower
Now consumers major borrowers
Now governments major borrowers
31. The Liquidity Preference (Cash Balances)
Theory of Interest Rates
The liquidity preference (or cash
balances) theory of interest rates
Short-term theory
Developed for explaining near-term
changes in interest rates
More relevant for policymakers
Developed by Jhon Maynard Keynes
(1936)
32. Keynes argued that the rate of interest is
really a payment for the use of a scarce
resource money
Businesses and individuals prefer to hold
money for carrying out daily transactions
and also as a precaution against future cash
needs.
Interest rates, therefore. are the price that
must be paid to induce money holders to
surrender a perfectly liquid asset and hold
other assets that carry more risk
33. The Liquidity Preference (Cash Balances)
Theory of Interest Rates
Rate of interest is the payment
For the use of their scarce resource
(liquidity)
By those who demand liquidity
Assumed outlet for funds
Bonds
Cash Balances (including bank deposit)
There are three elements of demand for
cash balances
35. Transactions motive
Economic units do not have a perfect
balance of inflows and outflows
Hold liquidity for purchase of goods
and services
Not overly sensitive to interest rates
5-35
36. Precautionary motive
Cannot predict future expenditures
precisely
Cope with future emergencies
Cover potential extraordinary
expenses
e.g. unanticipated medical expense
Greater in times of economic
uncertainty
Not overly sensitive to interest rate
movements
37. Speculative motive
Demand due to uncertainty in future
bond prices
Change in interest rates
Changes bond prices
Demand for cash balances substitute
for bonds
There is a negative relationship
between speculative demand for
money & interest rate.
38. Keynes assumed that money demanded for
transactions and precautionary purposes is
dependent on the level of national income,
business sales, and prices.
Money demand for precautionary and
transaction purposes to be fixed in the short
term.
In the longer term, however. transactions
and precautionary demands change as
income changes.
41. The Supply of Money
Modern governments control or closely
regulate money supply
Decisions concerning the size of the
money supply presumably guided by the
public welfare
So assume the supply of money (cash
balances) is inelastic with respect to
interest rates
Represented by a vertical supply curve in
the equilibrium
42. Total Demand for Money or Cash Balances
And the Equilibrium Rate of Interest
5-42
43. The Equilibrium Rate of Interest in
Liquidity Preference Theory
The interaction of the total demand for and the
supply of money determines the equilibrium
rate of interest in the short run.
Quantity of money demanded by public
equals supply provided by government
If the supply exceeds quantity demanded
at current interest rates
Buy bonds with excess funds
Decrease cash balances
Increase bond prices and lower interest rates
44. Insights
Provides some useful insights into
investor behavior and the influence of
government policy on the economy and
financial system
It is rational at certain times for the public
to hoard money (cash balances] and at
other times to dis-hoard spend unwanted
cash.
45. If the public disposes of some of its cash
by purchasing securities, this action
increases the quantity of loanable funds
available from the financial markets.
Other things being equal, interest rates
will fall
46. On the other hand, if the public tries to
"hoard" more money, (expanding its cash
balances by selling securities less money
will be available for loans.
Then interest rate will rise.
47. Limitations
The liquidity preference theory is a short-
term theory
Assumption that income remains stable
does not hold in the long-term
Only the supply and demand for money is
considered
Fails to consider the supply and
demand for credit by all actors in
financial system
businesses, households, and
governments
48. The Loanable Funds Theory of Interest
Loanable funds theory
Most popular practitioner theory
Risk-free interest rate is determined by the
interplay of two forces
the demand for credit (loanable funds) from,
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
49. 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
50. Consumer (household) demand for
Loanable fund
While borrowing, consumers are not
particularly responsive to the rate of
interest rather focus principally on non
price term of loan.
Maturity, down-payment, maturity of loan,
size of installment payment are important
factor.
Consumer (household) demand is
relatively inelastic with respect to the rate
of interest.
51. Domestic business demand for Loanable
Fund
More responsive to interest rate
change.
Domestic business demand increases
as the rate of interest falls.
Consider Cost of fund vs Expected rate
of return (IRR)
52. Government demand for Loanable Fund
Government demand does not depend
significantly upon the level of interest
rates.
Federal Govt. decision on spending and
borrowing are made by Congress in
response to social needs and public
welfare. (not rate of interest)
Moreover, they have the power to tax and
create money to pay its debt.
So, Demand is inelastic.
53. Local and State Govt demand is slightly
interest elastic.
Many Local Govt are limited in their
borrowing activities by legal interest rate
ceilings.
When open market rate rise, some local
and State Govt are prevented from offering
their securities to the public.
54. Foreign demand for Loanable Fund
Foreign demand is sensitive to the
spread between domestic and foreign
interest rates.
If domestic rate decline relative to
foreign rates, foreign borrowers will
eager to borrow more from domestic
market and less from abroad.
56. The supply of loanable funds
At least four different sources
1. Domestic savings by business,
consumers and Govt.
2. Dishoarding of Excess money balances
held by public
3. Creation of money by domestic banking
system.
4. Lending to domestic borrowers by
foreigners.
57. Domestic savings.
Principle source of Loanable fund.
Mainly done by household,
sometimes Business, and rarely
Govt.
Have to consider:
Income Effect
Substitution Effect
Wealth Effect ( Also, opposite effect)
58. The net effect of income, substitution,
and wealth effects is a relatively
interest-inelastic supply of savings
curve.
59. Dishoarding of money balances.
Difference between public total
demand for money and money supply
is known as hoarding.
When public’s demand for cash
balance exceeds the supply, positive
hoarding of money takes place.
Hoarding reduces the volume of
Loanable funds available in the
Financial marketplace.
60. When public demand for money is
less than supply available, negative
hoarding occurs
When individuals and businesses
dispose of their excess cash
holdings, the supply of loanable
funds available to others is increased.
61. Creation of credit by the domestic
banking system
Commercial banks and nonbank thrift
institutions offering payments accounts
can create credit by lending and investing
excess reserves.
It represents an additional source of
loanable funds which must be added to
the amount of savings and dis-hoarding of
money balances to derive the total amount
of Loanable fund in the economy.
63. The Loanable Funds Theory of Interest
Total Supply of Loanable Funds (Credit)
Interest
Rate
Amount of
Loanable Funds
Total Supply
= domestic savings +
newly created money +
foreign lending –
hoarding demand
65. This is a partial equilibrium position.
Here interest rate is affected by conditions
in both the domestic and world economies.
66. The Loanable Funds Theory of Interest
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
67. The Loanable Funds Theory of Interest
Interest rates will be stable only
when the economy, money market,
loanable funds market, and foreign
currency markets are simultaneously
in equilibrium.
70. 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.
71. Assumptions and Conclusions
1. The price of securities and interest rate
should reflect all available information
and market uses all of this information to
establish a probability distribution of
expected future price and return.
2. Changes in rates and security prices are
correlated only with unanticipated, not
anticipated information.
72. 3. The correlation between rates of return in
successive time periods is zero.
4. No unexploited opportunities for profit
(above a normal return) can be found in the
securities’ market.
5. Transactions and storage cost for
securities are negligible and information
costs are small relative to the value of
securities are traded.
73. 6. Expectations concerning future security
prices and interest rates are formed
rationally and efficiently.
74. Businesses and individuals are
Rational agents
Form expectations about distribution of
future security prices & interest rates that
does not differ from optimal forecast.
Make optimal use of resources to
maximize returns
75. Tend to make unbiased forecasts of
future asset prices, interest rates, and
other variables.
Make no systematic forecasting error,
identifies past error and rectifies it.
76. Under rational expectations, money
and capital markets are highly
efficient.
So, interest rates will always be at or
very near their equilibrium levels.
Any deviations dictated by demand
and supply forces will be almost
instantly eliminated.
77. Security traders hoping to earn windfall
profits from guessing are unlikely to be
successful in the long run.
Moreover, knowledge of past interest rate
will not be a reliable forecast in the future.
Indeed, according to the theory, in the
absence of new information, the optimal
forecast of next period’s interest rate
would probably be equal to the current
period interest rate i.e., {E(r t+1) = rt)}
78. Because, there is no particular reason for
next period’s interest rate to be either
higher or lower than today’s interest rate
until new information causes market
participants to revise their expectations.
Old news will not affect today’s interest
rates because those rates have already
impounded the old news.
79. Interest rates will change only if
entirely new and unexpected
information appears
Direction of change depends on the
public’s current set of expectations
New equilibrium based on revised
expectations
Speculators unlikely to consistently earn
windfall profits from estimating interest
rates
80. Knowledge of past interest rates not
reliable forecast of future rates
Optimal forecast equals current interest
rate
Changes only when information changes
expectations
82. Expected Demand for and
Supply of Loanable Funds
Can modify the loanable funds theory
equilibrium
Use expected demand for loanable funds,
instead of current demand
Use expected supply for loanable funds,
instead of current supply
The two meets at equilibrium
Lose the relation between interest rates
and current economic changes
84. The thoery argues that forecasting interest
rate requires knowledge of public’s current
set of expectations.
If new information is sufficient to alter
those expectations, interest rate must
change.
It creates problem for Govt policymakers.
So, theorist prefer “ Rate Hedging”
86. Limitations
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
Not all interest rates and security prices
appear to display the kind of behavior
implied by the theory.
