Financial Markets and

Institutions

Chapter 2:
Determination of Interest Rates
Relevance of Interest Rate Movements

❖ Do interest rate movements have an affect

on Financial Institutions? yes
❑ Interest rate movements affect the value of
securities, intrest
when the if high price
rate
,
the share
will be low

❑ Therefore affect the performance of all types

of financial institutions
will demand less loans and this will effect the
When the intrest rate is
high people
income of the bank.
pfederal Open market
Community

will
· The market
to the
react

news very

quickly

N
 Uses
top100
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 Loanable Funds Theory
❖ This theory is used to explain interest rate
movements.
– Interest rate is determined by the factors that
control the supply of and demand for loanable
funds.
What is the “demand for loanable funds”?
It refers to the borrowing activities of
households, businesses and governments.
-
 Houshold
Loanable Funds Theory Business

✓ Household Demand for Loanable Funds Foregin

✓ Business Demand for Loanable Funds Govern

✓ Government Demand for Loanable Funds

✓ Foreign Demand for Loanable Funds
 Loanable Funds Theory
① Household Demand for Loanable Funds
Why households demand loanable funds?
✓ To finance housing expenditures, like? house ,
car ,
credit card

The demand for loanable funds has an

inverse relationship with interest rate, what
does this mean? If the intrest high rate is then the

demand for housing loan

goes
down .

If the
fax it will
of
>
rate lead
decreases to the borrowing
-

increase
-

and the demand will go up

.

tax to
borrowing 4
intrest 4 borrowing to
 Loanable Funds Theory
② Business Demand for Loanable Funds
Why businesses demand loanable Funds?
✓ To invest in long-term and short-term
assets? To expand their business .

The demand for funds by business

depends on the number of projects to be 4GDD ↑
Borrowing
-

implemented
-

If the is will
·
economy growing (4GDP) the companies want
to expand because

the demand their increased

product
on
need to borrow
so
they from the bank

that the will bank

· The more projects has GNPV the more
company borrow from the
 Loanable Funds Theory
Government Demand for Loanable Funds
❑ Why governments demand loanable
funds?
❑Governments demand for funds is interest-
The gov ,
will buy >
-

rate
inelastic or insensitive.
-
-when theygov .
have dificit borrow from bank and the demand will
increase
intrest
from
given
any Foreign Demand for Loanable Funds
❑ Why foreign demand loanable funds?
✓ Foreign demand can either be by
governments or corporations.
The home country have intrest rate then
may high
you can barrow from the host company .
 · The Q of the loanable funds
to
demanded is
normally expected
Loanable Funds Theory
-

sensita
astic (more
be more
supplied
e loanable fund
of
Aggregate Demand for Loanable Funds
Is the sum of the quantities demanded by
1. Household -
2. Business -
3. Government -
4. Foreign -
The aggregate demand for loanable funds is
inversely related to interest rates.
the
If the demand loans a re
higher than the supply then

intrest will
rate go up
- -

-
Si
-
-

&

D2
Di
 market
* Bank Muscat money

Loanable Funds Theory * If I put my money in the

bank the
supply of the bank

Supply of Loanable Funds will

increase and that will lead for

This refer to funds provided to financial the supply of loans to increase.

markets by savers. mostly household

– The household sector is net supplier of -
H
<
supply
if
increase

intrest
rate

loanable funds. increase

Supply of loanable funds is directly related

to interest rate, what does this mean? >
-If the intrest
will be
rate
more
increases

encouraged
the household
to save

– The aggregate supply of loanable funds is the money

sum of all sectors.
 Si

Loanable Funds Theory i2 -

-
&

D A = SA
Equilibrium Interest Rate

– If the DA for loanable funds increases without

-
corresponding increase in SA ,
There will be shortage of loanable funds
- -

Interest rate will rise

-

If and demand grow in the same

magnitude
> the
supply
-

the intrest rate will be the same but the

quantity
will increase.

demand the time the intrest

If the supply and increase at seme

will be the .
same
Economic Growth:

• Demand for loans increases as businesses need more capital to Economic Forces that Affect Interest
expand and consumers feel more confident about spending.

• This increased demand pushes the equilibrium interest rate up (if

Rates
supply doesn’t increase enough), even though borrowers would prefer
lower rates. The higher demand for loans drives rates higher, ❑ Economic forces cause changes in the supply
regardless of borrowers’ preferences, because of competition for the
available funds. and demand of loanable funds
❑ which in turn move interest rate.
Economic Slowdown:
❖ Impact of Economic Growth on Interest Rates
• Central banks may lower interest rates to encourage borrowing, but
the demand for loans might still be lower because businesses and o Economic growth leads to more borrowing, because of the
-
purchasing power the people will
have
consumers are cautious about the economic outlook. -

This shift the aggregate demand to the right. (increases)

• Even though lower rates make borrowing cheaper, if people are
Supply shift as well but it is not clear which direction. eaither up or down.
uncertain about the future, they may still borrow less. The reduction in
borrowing demand helps push interest rates down further. o What happen to the equilibrium interest rate? it increase will

o How the equilibrium interest rate change in case of

economic slowdown? Yes it will go down , the demand for because

loans will go down because pplave uncertin

of the future of economey
.

↑
 Economic Forces that Affect Interest
Rates
#
grows
❖ Impact of Inflation on Interest Rates increases when the economy

o Inflation shift the supply curve to the left Si

·
o because households will reduce their savings
- -

o In the same time households and business will

demand more funds to finance their activities
-

before prices increase

to intrestrate
o this will shift the demand curve to the right. supply
o What happen to the equilibrium interest If the supply dec and the

rate? The intrest rate will increase as inflation increases .

demand inc the intrest
If the inflation rate is
higher them

will
anticipated >
-
t real rate >
- This

benifit

able
the borrower of

lower
they will

nominal
be

intrest
Impact of Inflation on Interest Rates
to borrow at a

rate

Fisher Effect
– Explains the relationship between interest
rates and expected inflation
-

- -

– The difference between the nominal interest

-

rate and the expected inflation rate is the real

return to a saver.
-
-

i r=i – E (INF); i r : real interest rate

-
inflation
reala nominal
intrest
rate
 increase the
to
• First Effect: The central bank increases the money supply the Way
supply of loanable funds increases interest rates go down.
Impact of the Money Supply on Interest money supply
:

• Second Effect: As borrowing increases due to cheaper credit

demand for loanable funds increases interest rates may rise if
Rates >
-

Open
market operations

T bills to Commercial
demand grows strongly. issue

When the Central Bank increases the

.

it
Banks and r repurchase
the
The ultimate effect on interest rates depends on the balance
-

between the increase in the supply of money (which lowers rates) supply of money, bank and give the bank their

and the rise in demand for loans (which pushes rates up). Often,
-

rate
– It increases the supply of loanable funds
intrest
money
+
.

interest rates decrease initially, but if demand surges, they may rise
-
again.
-

Which decrease interest rates and vice versa.

-
>
-

Discount Rate :
rate
the discount

o Increasing the money supply can also result in

will decrease
CBO
Commerical baks
to the
loans
-
when giveing
increasing the demand for loanable funds
- -
so that it will increase the money supply

able to loan
be
o which in turn leads to higher interest rates. B and will
of the C .

they

many
to the people .

of with stable Reserve

economey
a Ratio
growth
>
Achine :
-

amount that need to be kept

The
intrest rate
.
as a
.
buffer
will decrease the reserve
>
- The CBO

ratio of banks ex :
from 8-12 %
the
the
Lend more
money
to
so they can

.
people

Si

· I
I
(

!
&
 Economic Forces that Affect Interest
Rates
❖ Impact of a Budget Deficit on Interest land for increase
will

Rates for funds

the demand loanable which
more and
The >
-

gov ,
will borrow
of interest rate
.

❑ When government expenditures are higher

than its revenues, then a deficit is created.
❑This leads to higher demand for loanable
funds and higher interest rates.
borrow
❖Crowding-out effect? >
- the gov
can crowd out the market because

intrest
they
rate
can

than the
at

privet
a

sector.
higher

❑When the government is willing to pay higher

1
interest rates for its borrowing that the private
sector can’t.
the government is inelastic because
they will borrow at
any
intrest rate
.

for the
gov. to not crowed out the market
they:
① local banks
Borrow from the
minor amount
I issue bands to
fersiv
amount from the ferigh investments
② Borrow the major
 * The gov ,
will increase the
money supply to push

down the intrest the household

rate to help

Interest Rates and Economic Recession to

barrow

all
After
resection

P
US interest rates

~
Euro area interest rates

O
UK interest rates

O
Brazilian interest rates
 forign invester investes in oman

Economic Forces that Affect Interest Open

↓
a bank account

Rates put
↓
their money
in the bank

↓
Impact of Foreign Flows of Funds on increase money supply
Interest Rates Decrege
↓
intrest

– Large flows of funds between countries ↓

change the supply and demand for loanable increase
borrowing

funds
which result in movements in interest rate. will decrease.

The Asian Crisis is an example of foreign

funds flows out of the region that caused
-

low supply of loanable funds.

-

– The result was high interest rates in Asia.

-

When investers invest in countries other countries

the bank
They will take mony from the

↓
of ↓
supply money

↓
Intresta

Dis