Module : Part 2
Interest Rate Determination
The rate of interest
Interest rate is a rate of return paid by a borrower of funds to a lender of them, or a price paid by a
borrower for a service, the right to make use of funds for a specified period. Thus, it is one form of yield
on financial instruments. Two questions are being raised by market participants:
What determines the average rate of interest in an economy?
Why do interest rates differ on different types and lengths of loans and debt instruments?
Interest rates vary depending on the borrowing or lending decision. Interest rate movements have a direct
influence on the market values of debt securities, such as money market securities, bonds, and mortgages.
They have an indirect influence on equity security values because they can affect the return by investors
who invest in equity securities. Interest rate movements also affect the value of most financial institutions.
They influence the cost of funds to depository institutions and the interest received on some loans by
financial institutions.
Loanable funds theory
The loanable funds theory, commonly used to explain interest rate movements, suggests that the market
interest rate is determined by factors controlling the supply of and demand for loanable funds.
In an economy, there is a supply loanable funds (i.e., credit) in the capital market by households,
business, and governments. The higher the level of interest rates, the more such entities are willing to
supply loan funds; the lower the level of interest, the less they are willing to supply. These same entities
demand loanable funds, demanding more when the level of interest rates is low and less when interest
rates are higher.
The extent to which people are willing to postpone consumption depends upon their time preference.
The term ‘loanable funds’ simply refers to the sums of money offered for lending and demanded by
consumers and investors during a given period. The interest rate in the model is determined by the
interaction between potential borrowers and potential savers. The loanable funds theory was formulated
by the Swedish economist Knut Wicksell in the 1900s. According to him, the level of interest rates is
determined by the supply and demand of loanable funds available in an economy’s credit market (i.e., the
sector of the capital markets for long-term debt instruments). This theory suggests that investment and
savings in the economy determine the level of long-term interest rates. Short-term interest rates, however,
are determined by an economy’s financial and monetary conditions.
According to the loanable funds theory for the economy as a whole:
Demand for loanable funds = net investment + net additions to liquid reserves
Supply of loanable funds = net savings + increase in the money supply
Given the importance of loanable funds and that the major suppliers of loanable funds are commercial
banks, the key role of this financial intermediary in the determination of interest rates is vivid. The central
Module : Part 2
Interest Rate Determination
bank is implementing specific monetary policy, therefore it influences the supply of loanable funds from
commercial banks and thereby changes the level of interest rates. As central bank increases (decreases)
the supply of credit available from commercial banks, it decreases (increases) the level of interest rates.
FACTORS THAT AFFECT INTEREST RATES
The following economic factors influence this supply and demand and thereby influence interest rates.
1. Impact of Economic Growth on Interest Rates
Figure:2 Interest Rate Equilibrium
When businesses anticipate that economic conditions will improve, they revise upward the cash flows
expected for various projects under consideration. Consequently, businesses identify more projects that
are worth pursuing, and they are willing to borrow more funds. Their willingness to borrow more funds at
any given interest rate reflects an outward shift (to the right) in the demand curve. The supply-of-
loanable-funds schedule may also change in response to economic growth, but it is difficult to know in
which direction it will shift. It is possible that the increased expansion by businesses will lead to more
income for construction crews and others who service the expansion. In this case, the quantity of savings
(loanable funds supplied) could increase regardless of the interest rate, causing an outward shift in the
supply schedule.
2. Impact of Inflation on Interest Rates
Changes in inflationary expectations can affect interest rates by affecting the amount of spending by
households or businesses. Decisions to spend affect the amount saved (supply of funds) and the amount
borrowed (demand for funds).
3. Impact of Monetary Policy on Interest Rates
Bangladesh bank can affect the supply of loanable funds by increasing or reducing the total amount of
deposits held at commercial banks or other depository institutions.
4. Impact of the Budget Deficit on Interest Rates
Module : Part 2
Interest Rate Determination
When the government enacts fiscal policies that result in more expenditures than tax revenue, the budget
deficit is increased. Because of large budget deficits in recent years, the government is a major participant
in the demand for loanable funds. A higher government deficit increases the quantity of loanable funds
demanded at any prevailing interest rate, which causes an outward shift in the demand curve.
[Link] of Foreign Flows of Funds on Interest Rates
The interest rate for a specific currency is determined by the demand for funds denominated in that
currency and the supply of funds available in that currency.