CHAPTER THREE

INTEREST RATES IN THE FINANCIAL SYSTEM

3.1. The theory and structure of Interest Rates
What is interest rate?
 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.

Interest rates are a fundamental part of financial economics. They help us evaluate and compare
different investments or loans over time. However, if we compare financial data over time, we
have to consider the effects of inflation. This is why we distinguish between two different types
of interest rates: the nominal interest rate and the real interest rate. We will look at both of them
in more detail below.

Nominal Interest Rate

The nominal interest rate describes the interest rate without any correction for the effects of
inflation. Thus, the advertised or stated interest rates we see on bonds, loans or bank accounts are
usually a nominal one. This rate shows you the actual price you are paid (or have to pay) if you
lend (or borrow) money. Simply, it shows you by how much the amount of money you have in
your bank account increases over time.

To give an example, let’s assume you deposit 10’000 Birr in your bank account. The account
pays an annual interest rate of 7%. After one year your balance has increased to 10’700 Birr.
That means, you have accumulated 700 Birr in interest on your account. The annual interest rate
of 7% in this example is the nominal interest rate. However, if you are familiar with the concept
of inflation, you will know that this does not necessarily mean that you are in fact 700 Birr
“richer” now. As implied above, to see how much you can actually profit from a 7% nominal
interest rate, we need to consider the effects of inflation. And that’s where the real interest rate
comes into play.

Real Interest Rate

The real interest rate refers to the interest rate adjusted to remove the effects of inflation. This
rate shows you by how much the actual purchasing power of the money you have in your bank
account increases over time. In other words, it describes the real yield of lending money or
the real cost of borrowing money. Calculating the real interest rate is actually quite simple. All
we need to do is take the nominal interest rate and subtract the inflation rate. This equation is
also referred to as the Fisher equation.
Real Interest Rate = Nominal Interest Rate - Inflation
To illustrate this, let’s revisit our example. In one year, you accumulated 700 in interest with a
nominal interest rate of 7%. Now, let’s say during the same period, the overall price level in the
economy has increased by 2%. In this case, your money is worth less now than it was a year ago.
Its buying power has decreased, because now you need more money to buy the same amount of
goods. Therefore, to see how much you can actually profit from the additional 700 Birr, we need
to adjust for the effects of inflation. In our example, that means we subtract 2% (inflation rate)
from 7% (nominal interest rate), which results in a real interest rate of 5%. That means, your
actual buying power has increased by 5%.
3.2 THEORIES OF INTEREST
There are three economic theories explaining the level of real interest rates in an economy:
1. Classical Theory 3. Liquidity preference theory
2. The loan able funds theory
1. CLASSICAL THEORY
This theory is also regarded as savings and investment theory of rate of interest. According to
this theory the rate of interest is determined by the interaction of savings and investment. Interest
is regarded as a reward for savings in classical theory. The rate of interest is a real phenomenon
because it is determined by the real factors like savings, and investment,. The rate of interest is
not directly affected by the change in money supply. The change of supply of money can only
change the price level and not rate of interest. The rate of interest is really the equilibrium
mechanism which brings about equality between savings and investments. If there is
disequilibrium between savings and investment it is corrected by the rate of interest. (if savings
higher than investment-means more people ready to lend out money- leads to more supply than
demand-so rate of interest comes down to level of equilibrium. If investment higher than
savings-the demand for capital higher than supply of capital-this leads to rise in the rate of
interest till such time when equilibrium rate of interest is achieved). The rate of interest at which
savings and investment are equalized in the classical system is at some positive rate of interest.
There is no possibility of zero or negative rate of interest in classical system.
2. Neo-classical theory ( loanable funds theory)

The term ‘loanable funds’ simply refers to the sums of money offered for lending and demanded
by consumers and investors during a given period. In an economy, there is a supply loanable
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. 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. 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 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: 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.
3. 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
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.

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

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
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.