Chapter Three

Interest Rates in the Financial System

3.1. The theory and structure of Interest Rates

Interest rate is a rate of return paid by a borrower of funds to a lender of them. We can also think
of an interest rate as a price paid by a borrower for a service, the right to make use of funds for a
specified period. Of course, interest rates also vary depending on whether you are borrowing or
lending. For example, there is a spread between the interest rate at which banks are prepared to
lend (the offer rate) and the rate they are willing to pay to attract deposits the bid rate). There is
also a spread between selling and buying rates in international money markets. The interest rate
structure describes the relationships between the various rates of interest payable in an economy
on loans of different lengths (terms) or of different degrees of risk.

Real interest rate: the nominal rate of interest minus the expected rate of inaction.

It is a measure of the anticipated opportunity cost of borrowing in terms of goods and services
forgone. As we have suggested above, it is the expected rate of inflation over the period of a loan
that is of particular importance, rather than the present rate of inflation is considered.

r = I – p : Where

r= nominal rate

I=nominal interest rate

p= inflation rate

There are two economic theories explaining the level of real interest rates in an economy:

1. The loan able funds theory

Interest rate theories: loan able funds theory

In an economy, there is a supply loan able fund (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.
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These same entities demand loan able 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. Time preference describes the extent to which
a person is willing to give up the satisfaction obtained from present consumption in return for
increased consumption in the future.

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. Loanable funds are funds
borrowed and lent in an economy during a specified period of time – the flow of money from
surplus to deficit units in the economy. 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 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.

Interest rate theories: liquidity preference theory

Saving and investment of market participants under economic uncertainty may be much more
influenced by expectations and by exogenous shocks than by underlying real forces. A possible
response of risk-averse savers is to vary the form in which they hold their financial wealth
depending on their expectations about asset prices. Since they are concerned about the risk of

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loss in the value of assets, they are likely to vary the average liquidity of their portfolios. A liquid
asset is the one that can be turned into money quickly, cheaply and for a known monetary value.

Liquidity preference theory is another one aimed at explaining interest rates. J. M. Keynes has
proposed (back in 1936) a simple model, which explains how interest rates are determined based
on the preferences of households to hold money balances rather than spending or investing those
funds. Money balances can be held in the form of currency or checking accounts, however it
does earn a very low interest rate or no interest at all. A key element in the theory is the
motivation for individuals to hold money balance despite the loss of interest income.

Money is the most liquid of all financial assets and, of course, can easily be utilized to consume
or to invest. The quantity of money held by individuals depends on their level of income and,
consequently, for an economy the demand for money is directly related to an economy’s income.
There is a trade-off between holding money balance for purposes of maintaining liquidity and
investing or lending funds in less liquid debt instruments in order to earn a competitive market
interest rate. The difference in the interest rate that can be earned by investing in interest-bearing
debt instruments and money balances represents an opportunity cost for maintaining liquidity.
The lower the opportunity cost, the greater the demand for money balances; the higher the
opportunity cost, the lower the demand for money balance. Liquidity preference is preference for
holding financial wealth in the form of short-term, highly liquid assets rather than long-term
illiquid assets, based principally on the fear that long-term assets will lose capital value over
time. According to the liquidity preference theory, the level of interest rates is determined by the
supply and demand for money balances. The money supply is controlled by the policy tools
available to the country’s Central Bank. Conversely, in the loan funds theory the level of interest
rates is determined by supply and demand, however it is in the credit market.

The monetary authorities and the rate of interest

The general level of interest rates might change in an economy because the monetary authorities
change the rate of interest at which they are prepared to operate in the money market. This is
usually done in an attempt to influence the level of aggregate demand in the economy (and hence
the rate of inflation) or the net inflow of short-term capital into the economy (and hence the
exchange rate). Variations by the central bank in the interest (or discount) rate at which it is

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prepared to lend very short term to the commercial banks influence the form in which banks hold
their assets and, in particular, their willingness to make loans to their clients. This then affects
longer-term interest rates. This ability of the central bank to influence the general level of interest
rates does not, however, mean it fully controls rates of interest. There are several reasons for this.
One of the reasons is that the notion that the central bank can influence the willingness of banks
to make loans assumes that banks are profit maximizes and thus that any small change in the
costs of a liquidity shortage causes a response from banks. The behavior of banks certainly
shows that they are interested in keeping profits high, but they are also likely to have other
objectives. For instance, they may wish to maintain their share of the different markets in which
they operate. Banks are in competition with each other for both assets (including competing with
each other in the house mortgage market) and liabilities (competition for bank deposits). In order
to maintain their spread between borrowing and lending rates, banks that cut their lending rates
must also cut their deposit rates.

3.2 Factors affecting structure of Interest rate determinations

There are several factors that affect interest rates

1. Inflation

When you lend money now, the prices of goods and services may go up by the time you are paid
back, so your money's original purchasing power would decrease. Thus, interest protects against
future rises in inflation. A lender such as a bank uses the interest to process account costs as well
(the lender can protect inflation or the increment in the purchasing power of goods and services
by increasing interest rates). Inflation will also affect interest rate levels. The higher the inflation
rate, the more interest rates are likely to rise. This occurs because lenders will demand higher
interest rates as compensation for the decrease in purchasing power of the money they will be
repaid in the future. A lender may be reluctant to lend money for any period of time if the
purchasing power of that money will be less when it’s repaid; the lender will, therefore, demand
a higher rate (known as an “inflationary premium”). Thus, inflation pushes interest rates higher;
deflation causes rates to decline.

2. Supply and Demand

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Interest rate levels are a factor of the supply and demand of credit: an increase in the demand for
credit will raise interest rates, while a decrease in the demand for credit will decrease them.
Conversely, an increase in the supply of credit will reduce interest rates while a decrease in the
supply of credit will increase them. The supply of credit is increased by an increase in the
amount of money made available to borrowers. For example, when you open a bank account,
you are actually lending money to the bank. Depending on the kind of account you open (a
certificate of deposit will render a higher interest rate than a checking account, with which you
have the ability to access the funds at any time), the bank can use that money for its business and
investment activities. In other words, the bank can lend out that money to other customers. The
more banks can lend, the more credit is available to the economy. And as the supply of credit
increases, the price of borrowing (interest) decreases. The interest rate on each different type of
loan, however, depends on the credit risk, time, tax considerations (particularly in the U.S.) and
convertibility of the particular loan.

Risk refers to the likelihood of the loan being repaid. A greater chance that the loan will not be
repaid leads to higher interest rate levels. If, however, the loan is "secured", meaning there is
some sort of collateral that the lender will acquire in case the loan is not paid back (i.e. such as a
car or a house), the rate of interest will probably be lower. This is because the risk factor is
accounted for by the collateral.

3. Government

When the government buys more securities, banks are injected with more money than they can
use for lending, and the interest rates decrease. When the government sells security, money from
the banks is drained for the transaction, rendering less funds at the banks' disposal for lending,
forcing a rise in interest rates.

4. Types of Loans

Of the factors detailed above, supply and demand are, as we implied earlier, the primary forces
behind interest rate levels. The interest rate on each different type of loan, however, depends on
the credit risk, time, tax considerations (particularly in the U.S.) and convertibility of the
particular loan. Risk refers to the likelihood of the loan being repaid. A greater chance that the
loan will not be repaid leads to higher interest rate levels. If, however, the loan is "secured",
meaning there is some sort of collateral that the lender will acquire in case the loan is not paid
back (i.e. such as a car or a house), the rate of interest will probably be lower. This is because the
risk factor is accounted for by the collateral. For government-issued debt securities, there is of

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course very little risk because the borrower is the government. For this reason, and because the
interest is tax-free, the rate on treasury securities tends to be relatively low. Time is also a factor
of risk. Long-term loans have a greater chance of not being repaid because there is more time for
adversity that leads to default. Also, the face value of a long-term loan, compared to that of a
short-term loan, is more vulnerable to the effects of inflation. Therefore, the longer the borrower
has to repay the loan, the more interest the lender should receive.

5 Economic growths

When the economy is growing, consumers have jobs and savings to lend through banks, but they
must also borrow for large items, such as homes or cars, or to finance other purchases through
credit cards. As the demand for funds increases, interest rates rise and act as a ration for the
funds available. Of course, the opposite is also true; when the demand for funds is low, interest
rates fall. There are also additional factors that affect interest rates, including, the degree of
competition among financial institutions, the marginal productivity of capital, business
confidence, and expectations regarding future changes in asset prices, expectations regarding
future exchange rates, the international mobility of capital, and the average time preference of
the population.

Term structure of interest rates

Interest rates vary because of differences in the time period, the degree of risk, and the
transactions costs associated with different financial instruments. Let us begin by considering
differences in risk. Plainly, the greater the risk of default associated with an asset, the higher
must be the interest rate paid upon it as compensation for the risk. This explains why some
borrowers pay higher rates of interest than others. The degree of risk associated with a request
for a loan may be determined informally, based upon, for example, a company’s size, portability
or past performance; or, it may be determined more formally by credit rating agencies.
Borrowers with high credit ratings will be able to have commercial bills accepted by banks, find
willing takers for their commercial paper or borrow directly from banks at ‘fine’ rates of interest.
Such borrowers are often referred to as prime borrowers.

Those less favored may have to borrow from other sources at higher rates. Much the same
principle applies to the comparison between interest rates on sound risk- free loans (such as
government bonds) and expected yields on equities, the factors influencing that the more risky a
company is thought to be, the lower will be its share price in relation to its expected average
dividend payment – that is, the higher will be its dividend yield and the more expensive it will be
for the company to raise equity capital. Of course, not everyone is risk averse and shares of
companies that have made no profits and paid no dividends for several years continue to be
bought and sold and so the loading for risk that must be paid by risky companies need not
necessarily be very great. Interest rates payable on different forms of assets will also vary with

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transaction costs and these are subject to economies of scale. Thus, other things being equal, we
should expect rates of interest to be lower the larger the size of the loan.

Our principal concern here, however, is with instruments that differ only in their time period –
that is, there is an equal risk of default and no difference in transaction costs. The relationship
between interest rates on short-term securities and those on long-term ones can be represented on
a diagram known as the yield curve. Yield curve: Shows the relationships between the interest
rates payable on bonds with different lengths of time to maturity. That is, it shows the term
structure of interest rates.

1. The pure expectations theory of interest rate structure

This theory assumes that present long-term interest rates depend entirely on future short-term
rates. Lenders are taken to be equally happy to hold short-term or long term securities. Their
choice between them will depend only on relative interest rates. This theory also assumes that
investors are indifferent between investing for a long period on the one hand and investing for a
shorter period with a view to reinvesting the principal plus interest on the other hand. It follows
that, for instance, a series of five one-year bonds is a perfect substitute for a five-year bond. If
this were so, the proceeds from investing say £1,000 for one year and then reinvesting the returns
for another year and so on for five years must exactly equal the proceeds from buying a £1,000
five-year bond at the beginning.

Consider what would happen if this were not so. Suppose the proceeds from a long-term bond
were greater than from a series of short-term bonds. People would buy long-term bonds, pushing
up their price and pushing down the rate of interest on them. This would continue until there was
no advantage to be had from holding the long-term bonds. Then people would be indifferent
between the two types of bond. Thus, the long-term interest rate would depend entirely on the
expected future short-term rates.

The simplest form of this theory assumes that lenders have perfect information and know what is
going to happen to short-term interest rates in the future. In this case, the long-term interest rate
will be an average of the known future short-term rates. This relationship between long-term and
short-term rates can be expressed in the formula

(1 + i*)n = (1 + i1)(1 + i2)(1 + i3)...(1 + in)

where i* is the interest rate payable each year on a long-term bond and n is the number of years
to maturity of the bond; i1 is the rate of interest payable now on a one-year bond; i2 is the rate of
interest which will be payable on a one-year bond in a year’s time; i3 is the short-term rate two
years into the future, and so on. The pure expectations theory of interest rate structure – a
numerical example Assuming that lenders have perfect information, long-term interest rates will
be an average of the known future short-term rates. We assume that lenders know that short-term
rates over the next five years will be:

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year 1 8 per cent

year 2 10 per cent

year 3 11 per cent

year 4 12 per cent

year 5 9 per cent

Then, £1,000 invested in a one-year bond, with the proceeds being invested in a further one-year
bond in the subsequent year, will produce the following results:

Principal Interest rate Interest Capital + interest

year 1 £1,000 8 per cent £80 £1,080

year 2 £1,080 10 per cent £108 £1,188

We can calculate that for a two-year bond taken out at the beginning of year one to produce the
same results it would need to pay an interest rate of 9 per cent – the average of the two short-
term rates. What does this mean for the yield curve?

We can see that because it is known that short-term interest rates will rise over the following
year (from 8 per cent to 10 per cent), the interest payable on the two-year (long-term) bond must
be greater than that payable on the one-year (short-term) bond.

That is, the yield curve will be sloping upwards. Let us continue our figures, assuming that our
investor continues to re-invest in one-year bonds for each of the following three years. This will
give us:

year 3 £1,188 11 per cent £131 £1,319

year 4 £1,319 12 per cent £158 £1,477

year 5 £1,477 9 per cent £133 £1,610

It can be shown that, at the beginning of year one, the interest rate payable on three-year bonds
must have been 9.66 per cent (the average of 8, 10 and 11) and on four-year bonds 10.25 per
cent. In other words, as long as it is known that short-term interest rates are going to rise, the
yield on long-term bonds for the equivalent period must lie above the short-term rate at the
beginning of year one and must be rising. The yield curve will be sloping up. However, what
about the interest rate at the beginning of year one on a five-year bond? Because it is known that
short-term interest rates will begin to fall in year five, so too will the interest rate on a five-year
bond. To produce a sum of £1,610 at the end of five years, the interest rate on a five-year bond
will need to be only 10 per cent and the yield curve will begin to turn down.

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 Term premiums

However, people do not have perfect information about the future course of short-term interest
rates. All they can have are estimates of these rates, which are subject to the risk of error. The
further into the future we try to look; the greater is the chance that we shall be wrong. Suppose a
lender acquires a long-term bond that pays an interest rate related to expect short-term interest
rates but then finds that short-term rates rise above the expected level. As current interest rates
rise, the prices of existing bonds fall, and bond holders suffer a capital loss. The expectations
view of the term structure of interest rates assuming risk aversion:

2. Market segmentation

According to the market segmentation theory, interest rates for different maturities are
determined independently of one another. The interest rate for short maturities is determined by
the supply of and demand for short-term funds. Long-term interest rates are those that equate the
sums that investors wish to lend long term with the amounts that borrowers are seeking on a
long-term basis. According to market segmentation theory, investors and borrowers do not
consider their short-term investments or borrowings as substitutes for long-term ones. This lack
of substitutability keeps interest rates of differing maturities independent of one another. If
investors or borrowers considered alternative maturities as substitutes, they may switch between
maturities. However, if investors and borrowers switch between maturities in response to interest
rate changes, interest rates for different maturities would no longer be independent of each other.
An interest rate change for one maturity would affect demand and supply, and hence interest
rates, for other maturities.

Liquidity Premium and Preferred Habitat Theories

Consider the relationship we have so far proposed between short-term and long-term interest
rates. Take our comparison between interest rates on one-year and on five-year bonds. Assume
the current one-year bond rate is 8 per cent while 10.5 per cent is payable on a five-year bond
indicating:
- That short-term rates are expected to rise in the future;
- That borrowers prefer to borrow long; and
- That lenders require a term premium to persuade them to lend long (that is, they are capital risk
averse). Suppose next that the current one-year rate unexpectedly falls to 7.5 per cent. Five-year
bonds at 10.5 per cent will now seem more attractive than before and people will switch towards
them, pushing up their price and forcing interest rates on them below 10.5 per cent. The position
of the yield curve will change, but there will be no change in its shape. It is often assumed that
this will happen very quickly that is, that short-term and long-term rates are closely linked. In
effect, we are assuming that there is a single market for funds and changes in one part of the
market are quickly communicated to other parts of it. Alternatively, they may, as with banks and

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building societies, need to keep a proportion of their assets in very liquid form in order to be able
to meet unexpected calls upon them. Again, they may wish to have funds available in case they
want to switch from financial assets into goods (increase purchase of consumer durables) or to
meet unexpected debts.
Further, the transaction costs involved in switching from one type of asset to another may be
very high or people may be poorly informed about the different types of asset available and the
interest rates payable on them. The market for funds, we are saying, may be segmented. Some
savers choose short-term securities; others choose long-term ones, irrespective of the difference
in interest rates between them. Long-term bonds are not substitutes for short-term ones. Instead
of thinking of a continuous yield curve showing the relationship between interest rates on assets
of different maturities, we could think of a series of separate markets for assets of different
maturities, with the interest rates payable on each type of asset being determined simply by
demand and supply for that asset. There would be no link between the different interest rates.
The significance of term structure theories;

3. Preferred habitat

Preferred habitat theory is a variation on the market segmentation theory. The preferred habitat
theory allows for some substitutability between maturities. However the preferred habitat theory
views that interest premiums are needed to entice investors from their preferred maturities to
other maturities. It is easy to think of groups of savers that may be strongly attached to particular
parts of the market for funds – for instance, small savers who habitually save in National Savings
or building society accounts despite changes in interest rate differentials, or those financial
institutions which have a definite preference for one part of the market. Nonetheless, the notion
that there is no substitutability among assets of different maturities appears extreme.

Imperfect Substitutions

That is, assets of different maturities are substitutes for each other, but are imperfect substitutes.
In our numerical example, the fall in current one-year interest rates from 8 to 7.5 per cent may
have little or no effect on five-year rates; but if one-year rates fell to say 7 per cent, we might
expect some switching towards long-term assets and some fall in the five-year rate, although we
would also expect the gap between –[; one-year and five-year rates to grow.

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