DETERMINATION OF
INTEREST
6.53
RATES
CHAPTER 2
WHY DO WE
CARE ABOUT
INTEREST RATES?
Interest rates reflect:
• The borrower’s cost of borrowing
• The investor’s rate of return
Using anticipated interest rates, participants can:
• Capitalize on their expectations
• Monitor potential cost of borrowing or
potential return
Therefore, it helps participants restructure/plan
their loans or investment.
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HOW TO ANTICIPATE
INTEREST RATES?
Loanable Funds Theory
- Suggests that the market interest rate is determined by factors
controlling the supply of and demand for loanable funds.
❖ Demand for loanable funds
- Refers to the borrowing activities of deficit units.
- Net demanders: businesses and governments
❖ Supply for loanable funds
- Refers to funds provided to financial markets by
savers.
- Net suppliers: households as a group
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DEMAND FOR LOANABLE FUNDS
& THE DEMAND CURVE
HOUSEHOLDS
Why do they demand funds? Borrowing Preference
Demands loanable funds to finance short- Willing to borrow more money at lower
term expenditure (housing expenditure rates of interest
such as food, clothing, other basic needs)
and long-term expenditure (e.g., long term
assets like house, lot, car) resulting in
installment debt.
The demand curve
(Demand-for-loanable funds
Schedule)
Downward to the right
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BUSINESSES
Why do they demand funds?
To invest in short-term needs (i.e., for day-
to-day operations) and fixed assets (for
business projects and expansion)
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SIDE NOTE: (THE NPV)
The net The initial investment The PV of
present value (negative because it cash inflows
of cash flows is a cash outflow)
Which projects to accept? Influence of interest rate
Projects with positive NPV (meaning, the The higher the cost of borrowing,
benefit outweighs the cost) or those that the higher the initial investment of the
exceeded the hurdle rate (the minimum project (since these are likely borrowed),
rate of return on a project required) Hence PV of cash inflows should be higher
to have a positive NPV
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BUSINESSES
Why do they demand funds? Borrowing Preference
To invest in short-term needs (i.e., for day- Likely to demand more funds when interest
to-day operations) and fixed assets (for rates are lower
business projects and expansion)
The demand curve
Downward to the right
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GOVERNMENT
Why do they demand funds? Borrowing Preference
To support government expenditures that Interest-inelastic (i.e., insensitive to interest
cannot be covered by its incoming rates)
revenues such as taxes
The demand curve
When government deficit
increases, the government
would still increase its
borrowing regardless of
the interest rate
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FOREIGN DEMAND
Why do they demand funds? Borrowing Preference
For more sources of loanable funds If the foreign country’s domestic interest rates
are higher relative to Philippine rates, the
higher the demand for Philippine funds.
This means that the cost of borrowing in the Philippines is
cheaper, hence foreign countries prefer to borrow here.
The demand curve
Downward to the right
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AGGREGATE DEMAND FOR LOANABLE FUNDS
The sum of the quantities
demanded by the separate sectors
at any given interest rate
Other things being equal, the
aggregate demand for loanable
funds is inversely related to the
prevailing interest rate
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SUPPLY OF LOANABLE FUNDS
& THE SUPPLY CURVE
SUPPLY OF
LOANABLE FUNDS
Investment Preference
Other things being equal, suppliers of loanable funds are willing to
supply more funds if the interest rate is higher. The interest rate is
the return for lending.
The Supply Curve
The supply-of-loanable-funds schedule; upward to the right.
Aggregate Supply of Loanable Funds
Represents the combination of all
sector supply schedules.
Notice that the supply curve is
steeper than the demand curve.
This means demand curve is
more sensitive to interest rates
than supply curve.
THEREFORE…
INVERSE DIRECT
The relationship of The relationship of
interest rates and the interest rate and the
demand for loanable supply of loanable funds
funds
Demand curve is Supply curve is upward
downward sloping sloping
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THE EQUILIBRIUM INTEREST RATE
EQUILIBRIUM INTEREST RATE
Algebraic Presentation
In equilibrium, the aggregate demand for loanable funds is equal to the the aggregate supply of loanable funds.
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EQUILIBRIUM INTEREST RATE
Graphical Presentation
The equilibrium interest rate, (i) is
the rate where the demand curve
and the supply curve intersect.
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DISEQUILIBRIUM, SHORTAGE, AND SURPLUS
𝐷𝐴 ≠ 𝑆𝐴 𝐷𝐴 > 𝑆A = ↑ in % 𝑆𝐴 > 𝐷A = ↓ in %
DISEQUILIBRIUM SHORTAGE SURPLUS
When disequilibrium Borrowers will not be Some suppliers of
exists, market forces able to obtain all funds funds will be unable to
should cause an that they desire at the successfully supply
adjustment in interest disequilibrium rate. their funds.
rates until equilibrium is
achieved.
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GRAPHICAL PRESENTATION
i D vs S State % Effect
4% 50 = 50 Equilibrium as is
3% 100 > 10 Shortage increase
5% 10 < 100 Surplus decrease
Remember, the demand
curve has an inverse
relationship with the interest
rate while the supply curve
has a direct relationship with
the interest rate.
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FACTORS THAT CAUSE THE CURVES
FOR LOANABLE FUNDS TO SHIFT
Movement Change of quantity of loanable funds
along the due to changes in the interest rate
curve
Occurs when the quantity of loanable
Shift in funds changes in response to a
change in other factors besides
the curve interest rates; causing a movement in
the equilibrium interest rate
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THE
SUPPLY
CURVE…
Shifts to the right
If there is an increase in the supply of
loanable funds
Shifts to the left
If there is a decrease in the supply of
loanable funds
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THE
DEMAND
CURVE…
Shifts to the right
If there is an increase in the demand for
loanable funds
Shifts to the left
If there is a decrease in the demand for
loanable funds
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FACTORS THAT CAUSE
SUPPLY CURVE
TO SHIFT
• Wealth
• Risk
• Near-term spending
• Monetary expansion
• Economic conditions
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1. WEALTH
Impact on
Shift in the supply Relationship on
Factor equilibrium interest
curve equilibrium rate
rate
a. As the total wealth of
financial market
participants increases, the To the right Decrease
supply for investment
increases
Inverse
b. As the total wealth of
financial market
participants decreases, the To the left Increase
supply for investment
decrease
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2. RISK OF A FINANCIAL SECURITY
Impact on
Shift in the supply Relationship on
Factor equilibrium interest
curve equilibrium rate
rate
a. As the risk of a financial
security decreases, it
becomes more attractive To the right Decrease
to suppliers of funds.
Direct
b. As the risk of a financial
security increases, it
becomes less attractive to To the left Increase
suppliers of funds.
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3. NEAR-TERM SPENDING NEEDS
Impact on
Shift in the supply Relationship on
Factor equilibrium interest
curve equilibrium rate
rate
a. When financial market
participants have few near-
term spending needs, the To the right Decrease
supply of loanable funds
increases
b. When financial market Direct
participants have
increased near-term
To the left Increase
spending needs, the
supply of loanable funds
decreases
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Fiscal
policy
THERE ARE
2 WAYS THAT THE Government spending and taxes
GOVERNMENT CAN
INFLUENCE THE
Monetary
ECONOMY policy
Supply of money, cost of money and
the rate of interest
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4. MONETARY EXPANSION
Impact on
Shift in the supply Relationship on
Factor equilibrium interest
curve equilibrium rate
rate
a. When monetary policy
objectives are to allow the
economy to expand the To the right Decrease
government increases the
supply of funds
b. When monetary policy Inverse
objectives are to restrict
the rate of economic
To the left Increase
expansion, the
government decreases the
supply of funds
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5. ECONOMIC CONDITION OF A COUNTRY
Impact on
Shift in the supply Relationship on
Factor equilibrium interest
curve equilibrium rate
rate
a. As the underlying economic
conditions themselves
improve in a country relative To the right Decrease
to other countries, the flow of
funds to that country increases
b. When economic conditions in Inverse
foreign countries improve,
domestic and foreign
To the left Increase
investors take their funds out
of domestic financial markets
and invest abroad
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FACTORS THAT CAUSE
DEMAND CURVE
TO SHIFT
• Utility derived from assets purchased with
borrowed funds
• Restrictiveness of nonprice conditions on
borrowed funds
• Economic conditions
• Inflation and Fisher effect will be discussed in
the next chapter.
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1. UTILITY DERIVED FROM ASSETS PURCHASED
WITH BORROWED FUNDS
Impact on
Shift in the Relationship on
Factor equilibrium interest
demand curve equilibrium rate
rate
a. As the utility derived from an
asset purchased with
borrowed funds increases, the To the right Increase
willingness to borrow
increases
Direct
b. As the utility derived from an
asset purchased with
borrowed funds decreases, To the left Decrease
the willingness to borrow
decreases
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Fees, collateral,
covenants
2. RESTRICTIVENESS OF NONPRICE CONDITIONS
ON BORROWED FUNDS
Impact on
Shift in the Relationship on
Factor equilibrium interest
demand curve equilibrium rate
rate
a. As the nonprice restrictions
put on borrowers as a
condition of borrowing To the right Increase
decrease, the willingness to
borrow increases
Inverse
b. As the nonprice restrictions
put on borrowers as a
condition of borrowing To the left Decrease
increase, the willingness to
borrow decreases
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3. ECONOMIC CONDITIONS
Impact on
Shift in the Relationship on
Factor equilibrium interest
demand curve equilibrium rate
rate
a. When the domestic economy
experiences a period of
growth, market participants To the right Increase
are willing to borrow more
heavily
Direct
b. When domestic economic
growth is stagnant, market
participants reduce their To the left Decrease
demand for funds
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FORECASTING INTEREST RATES
1 2
Estimating aggregate Focus more on changes
levels in a sector than on
estimating their
aggregate levels
ND = DA - SA
If ND is positive, % increase
If ND is negative, % decrease
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END OF
CHAPTER 2
Assignment:
• Please check eLearn Chapter 2
for the link.
• Due date: August 26, 4 PM
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