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DETERMINANTS OF INTEREST
RATES
CLASS MODE REVISION
Completed
EXAM WEEK 2
FILES
NOMINAL INTEREST RATES
What are nominal interest rates?
Nominal interest rates are interest rates is commonly observed in a
financial market
Nominal interest rates affect? 2
The price or value of securities being traded at the money or capital
market
It also affect spot and forward currency exchange
When is nominal interest rates use?
It is used in determining the present fair value and for the price of the
securities
2 types of component?
Opportunity cost
Adjustments for individual security characteristics
LOANABLE FUNDS THEORY
DETERMINANTS OF INTEREST RATES 1
What is the deal with loanable funds theory?
Loanable funds theory explains interest rates and interest rates movement
It also emphasizes that equilibrium interest rates is actually the result of
the demand and supply of loanable funds
What is the difference between supply of loanable funds and demand for
loanable funds?
SUPPLY OF LOANABLE FUNDS = term used for the funds being supplied
by net fund suppliers
DEMAND FOR LOANABLE FUNDS = term used for the funds being
demanded by fund users
Who are the suppliers in the loanable funds framework?
The suppliers in the loanable funds framework are the financial market
participants
Who are the demanders of fund based on the the framework?
Consumers
Business
Government
Foreign market participants
SUPPLY OF LOANABLE FUNDS
In general, the quantity of loanable funds supplied increase as?
The quantity of loanable funds supplied increased as the interest rates
also increase
Explain figure 2.2 both for demand and supply of loanable funds
DETERMINANTS OF INTEREST RATES 2
📌 With all the other things being constant, the higher the supply when
interest rates are high. For demand, the higher the demand as the
rates decrease since the cost of borrowing is less
Who is the largest supplier of loanable funds in the US in 2010? Why do they
supply funds?
Households are the largest supplier of loanable funds in the US especially
if they have excess income or if they just want to reallocate their asset
portfolio holdings
What is the deal if the total wealth of the consumer increase?
If the total wealth of the consumer increase hence the total funds
being supplied also increases
What are the factors or basis of a household in supplying funds? 4
Total wealth
Interest rates
Risks of the securities = the higher the risk in the securities, the lower
the possibility that they will invest
DETERMINANTS OF INTEREST RATES 3
Immediate spending needs
In a business sector, what affects their overall supply of funds? 3
Risk in the securities
Interest rates
The investment needs of the business in the future
Do governments also supply funds?
Governments also supply funds. They actually generate more cash flows
that their budget.
What do governments do if their is a financial crisis?
If their is a financial crisis, the government actually supply more funds
to the business and consumers to help the overcome the recession
DEMAND FOR LOANABLE FUNDS
In general, the quantity of loanable funds demand is higher?
If the quantity of loanable funds demand is higher, interest rates decrease
Do households even though they are net suppliers also borrows funds from
markets?
Yes household still borrow even though they are are net suppliers.
The demand for loanable funds by household actively reflects?
House financing needs (mortgage)
Durable goods (appliances, cars)
Non-durable goods Education)
What is the deal with businesses whose interest rates are higher?
Businesses whose interest rates are higher they prefer to finance
investments with internally generated funds such as retained earnings
than borrowing funds
In a business setting when is the demand for loan funds greater?
DETERMINANTS OF INTEREST RATES 4
The demand for loan funds are greater if the there is greater number of
projects available to the businesses or the overall economic conditions is
better
What do state and local governments often issue? For what purpose?
State and local governments often issue debt issue to finance temporary
imbalances between operating revenues (taxes) and budget expenditures
What can higher interest rates cause to state and local governments?
Higher interest rates can cause state and local governments to postponed
borrowings thus capital expenditures
What is the deal with foreign borrowers?
Foreign borrowers Business, Household, Government) still participate in
the US Markets since they tend to find the cheapest source of dollar
Most foreign borrowers actually came from:
BUSINESS SECTOR
EQUILIBRIUM INTEREST RATE
What is the aggregate supply of loanable fund? How is it related to interest
rates?
The aggregate supply of loanable fund is the total sum of the quantity
funds supplied by the separate fund supplying sectors
Positively related to interest rates
What is the aggregate demand for loanable funds? How is it related to
interest rates?
Aggregate demand for loanable funds is the total sum of the quantity
demanded by the separate fund demanding sectors
Inversely related to interest rates
Explain Figure 2.3
Equilibrium interest rate is the rate that equates that aggregate supply of
loanable fund and aggregate demand of loanable fund
DETERMINANTS OF INTEREST RATES 5
There are some cases wherein the interest rate is higher than the
equilibrium interest due to having a surplus of funds. Hence, the suppliers
increase the interest rate to a rate that they are willing to offer for the
demanders to absorb the surplus of funds
There are also some instances wherein the interest rate is higher than the
equilibrium interest rate which is due to shortage of funds which resulted
to some demanders not able to have access to funds which will later on
resulted for some demanders to exit the market. On the other hand, this is
an opportunity for more suppliers to enter the market.
DETERMINANTS OF HOUSEHOLD SAVINGS
What are the determinants of household savings? 5
Interest rates and tax policy
Income and wealth
DETERMINANTS OF INTEREST RATES 6
Attitudes about saving versus borrowing
Credit availability
Job security and belief in soundness of entitlements
DETERMINANTS OF FOREIGN FUNDS INVESTED IN
THE US
What are the determinants of foreign funds invested in the US? FRES
Foreign central bank investment in US
Relative interest rates and returns on global investments
Expected exchange rate changes
Safe haven status of U.S Investments
FACTORS THAT CAUSE SUPPLY AND DEMAND
CURVES TO SHIFT
Wealth & Income
EFFECT IN SUPPLY Increase
EFFECT IN DEMAND N/A
RESULT Lower interest rates
Risk
EFFECT IN SUPPLY Decrease
EFFECT IN DEMAND Decrease
RESULT Higher interest rates
Near term spending needs
EFFECT IN SUPPLY Decrease
EFFECT IN DEMAND N/A
RESULT Higher interest rates
Monetary expansion
DETERMINANTS OF INTEREST RATES 7
EFFECT IN SUPPLY Increase
EFFECT IN DEMAND N/A
RESULT Lower interest rates
Economic growth
EFFECT IN SUPPLY Increase
EFFECT IN DEMAND Increase
RESULT Indeterminate interest rates but as the growth increase rapily,
interest rates also rise
Utility derived from assets
EFFECT IN SUPPLY Decrease
EFFECT IN DEMAND Increase
RESULT Higher interest rates
Restrictive covenants
EFFECT IN SUPPLY Increase
EFFECT IN DEMAND Decrease
RESULT Lower Interest Rates
Tax Increase
EFFECT IN SUPPLY Decrease
EFFECT IN DEMAND Increase
RESULT Higher interest rates
Currency Appreciation
EFFECT IN SUPPLY Increase
EFFECT IN DEMAND N/A
RESULT Lower Interest Rates
Expected Inflation
EFFECT IN SUPPLY Decrease
DETERMINANTS OF INTEREST RATES 8
EFFECT IN DEMAND Increase
RESULT Higher Interest Rates
DETERMINANTS OF INTEREST RATES 9