Determination of Interest rate

Interest rate:

• An interest rate can be defined as the price (or rent )paid by a

borrower (user) to a lender (owner) for the use of that economic
resource (funds), which will be used by the borrower during certain
time period and will be returned to owner.

• Interest rates are important since they affect:

– the level of consumption, savings and investments
– used in the pricing of other financial assets and securities.

• There are different concepts like:

– Real/Nominal rate
– Risk-free/Risk adjusted rate
– Short-term/Long-term rate
Defining the movements of interest rate –Loanable fund
theory

• Interest rate represents cost of debt

to borrowers and reward for providing credit to
creditors
• Market interest rate is determined by the factors that
control the supply of and demand for loanable fund.
• Intersection between supply curve and demand curve
results in equilibrium rate
Demand for loanable fund :

Household Demand for loanable fund :

•Demand loanable fund to
–Finance housing expenditure, purchasing automobiles, household
items, which results in installment debt.
• Relation to Interest rate
–Inverse relation
Shift in Household Demand for loanable fund
Change in Demand for loanable fund due to
income effect, economic growth, inflation etc.
Business Demand for loanable fund

• Demand for loanable fund of business to

– Invest in long term and short term assets.

Demand for loanable fund of business depends on the number of business available to
be implemented where a project evaluation is done by comparing the net present value
of its cash flow in the following way:
NPV= -INV + sum of present value of expected cash flows
NPV has a negative relation with interest rate.

• Relation with interest rate: inverse

• Short term fund demand comes from long term investment which means that
the relation to interest rate is also inverse here.
Shift in Business Demand for loanable fund

• Demand of loanable fund of Business may change due to

– In reaction to any events that effect business borrowing
preferences.

Government Demand for loanable fund

• Demand for loanable fund of Government occur when

– Government planned expenditure cannot be completely covered by its incoming revenues and taxes.
• Relation to Interest rate
– Government expenditure is free of interest rate and said to interest-inelastic.
Aggregate demand for loanable fund :
Aggregate supply for loanable fund :
How the Risk-Free Interest Rate
Is Determined

Exhibit 5A.1: How an Equilibrium Interest Rate Is Determined

Why Interest Rates Change

• Shift in the supply curve

– Increase in saving causes supply curve to shift
outward, lowering equilibrium interest rate
– Shift in monetary policy: the actions taken
by the Federal Reserve to control the
money supply
• Money supply: demand deposits and currency held by
the public
• Open market operations: the Fed’s buying and selling of
Treasury securities
Why Interest Rates Change

Exhibit 5A.2 Impact of an Inward Shift in the Supply Schedule

Why Interest Rates Change

• Shift in the demand curve

– Any factors that cause a change in the demand
for funds
– Shift in the government demand for funds
– Shift in the business demand for funds
– Shift in the household demand for funds
• Combining the factors — changes often occur
as the result of a combination of factors
Why Interest Rates Change

Exhibit 5.A3: Impact of an Outward Shift in the Demand Schedule

 Economic forces that Affect the demand for and supply of loanable
fund:

Factors Expectation Impact on Demand Impact on Supply Impact on Interest

rate

Optimistic An outward dhift in Demand No obvious change Upward pressure

Economic growth schedule
Pesimistic An inward dhift in Demand May an outward shift Downward
schedule pressure
Expected to An outward shift in Demand curve An in ward shift in Upward pressure
Inflation increase supply curve
Expected to An inward dhift in Demand an outward shift Downward
decrease schedule pressure

Expected to An inward dhift in Demand an outward shift Downward

increase schedule pressure
Money Supply
Expected to An outward shift in Demand curve An in ward shift in Upward pressure
decrease supply curve

Budget shift Expected to An outward shift in Demand curve No obvious change Upward
increase

An inward dhift in Demand No obvious change Upward

schedule
Fisher’s Classical Approach
• Supply of Savings
– Marginal rate of time preference
– Income
– Reward for saving
• Demand for Borrowed Resources
– Marginal productivity of capital
– Rate of interest
• Equilibrium Rate of Interest
Financial Markets, Chapt 11 Interest Rate 15
Fisher’s Law
• Nominal Rate of Interest (i)
• Real Rate of Interest (r)
• Premium for Expected Inflation (p)
• Fisher’s Law

(1 + i) = (1 + r)(1 + p)
or
i=r+p
Financial Markets, Chapt 11 Interest Rate 16
The Liquidity Preference Theory
 Demand for Money Balances depends
on 3 motives:
– Transactions Motive
– Precautionary Motive
– Speculative Motive
 Supply of Money determined by
exogenous policy of central bank
 Equilibrium Rate of Interest
Financial Markets, Chapt 11 Interest Rate 17
Interest Rates on Deposits and
Loans
• Interest rates on deposits and loans affect
your cash inflows and outflows
• Certificate of deposit: an instrument
that is issued by a depository institution
and specifies a minimum investment,
an interest rate, and a maturity
• Risk-free rate: a return on an investment that
is guaranteed for a specified period
Interest Rates on Deposits and
Loans
• Risk premium: an additional return beyond
the risk-free rate that can be earned from a
deposit guaranteed by the government
• Loan rate — financial institutions loan money
at a rate higher than they pay depositors
– Individuals with a poor credit history pay higher
rates
• Broad money supply and Banks
• • QUESTION: How much money (M1) is created from a monetary
• basis (M0) ?
• • ANSWER: It depends on the public’s desired cash ratio (c) and
• the banking system’s reserve ratio.
• Assume: Banks’ ratio of cash reserves (R) to deposits (D) is 10%
• and
• The public’s ratio of cash in circulation (C) to bank deposits (D) is
• 20%, the funds from an initial deposit £100m much higher broad
• money supply through further deposits:
• Subsequently, more deposits and loans will be created:
• Liabilities Assets
• Deposit 1: £100m Cash Reserves: £10m
• Advances: £90m
• The flow and use of money
• The basic features of the money flow in the economy are:
• • The public keeps a proportion of their money in cash and deposit
• the rest in a bank.
• • The bank keeps a proportion of this liability in cash and on-lends
• the rest creating more money in circulation.
• • Therefore, demand deposits qualify as money, since they enable
• money holdings to be transferred from one party to another.
• • Banks use the fact that not all customers will withdraw their
• deposits at the same time and on-lend them to borrowers, which
• creates new deposits, i.e. new money.
• Broad money supply and Banks 2
• Liabilities Assets
• Deposit 1: £100m Cash Reserves 1: £10m
• Advances 1: £90m
• Deposit 2: £72m Cash Reserves 2: £7.2m
• Advances 2: £64.8m
• Deposit 3: £51.84m Cash Reserves 3: £5.184m
• Advances 3: £46.656m
• ……….……. ………………
• Deposits
• £333.33m
• Cash Reserves £33.33m
• Advances £300.00m
Interest Rates on Deposits and
Loans
Interest Rates on Deposits and
Loans
Interest Rates on Deposits and
Loans
• Impact of changes in interest rates
– Rising interest rates increase the amount
of interest paid on deposits but also increases
the amount of interest charged on loans
• Comparing interest rates and banks
– Choice is dependent on your risk tolerance
and your financial situation
Term Structure of Interest Rates

• Term structure of interest rates:

the relationship between the maturities
of risk-free debt securities and the
annualized yields offered on those
securities
– Often based on rates of return offered by
U.S. Treasury securities with different
maturities
Term Structure of Interest Rates

Exhibit 5.4: Annualized Deposit Rates Offered on Deposits with Various

Maturities
Term Structure of Interest Rates

Exhibit 5.5: Comparison of Interest Rates among Deposits

Term Structure of Interest Rates

• Shifts in the yield curve

– Graphs such as the one on the previous
slide can be found in financial publications
such as the Wall Street Journal and
illustrate how returns change over time
Term Structure of Interest Rates

Exhibit 5.6: Treasury Security Yields

Financial Planning Online:
Updated Treasury Yields
• Go to: [Link]
• Click on: U.S. Treasuries
• This Web site provides yields of
Treasury securities with various
maturities.
How Banking Services Fit within
Your Financial Plan
• The key banking decisions for your
financial plan are:
– What banking service characteristics are
most important to you?
– What financial institution provides the best
banking service characteristic for you?
Integrating the Key Concepts
Integrating the Key Concepts

• Part 1: Financial Planning Tools

• Part 2: Liquidity Management
– In Chapter 5 we learned about banking and interest rates
– Chapter 6 teaches about managing your money
– Chapter 7 teaches about managing your credit
• Part 3: Financing
• Part 4: Protecting Your Wealth
• Part 5: Investing
• Part 6: Retirement and Estate Planning
Financial Planning Online:
Fed’s Upcoming Meetings
• Go to: http://
[Link]/bbn/[Link]
• This Web site provides updated
information about the Fed’s recent
actions and upcoming meetings.