Chapter: 3
Interest Rates in the Financial
System
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3.1. Introduction
The rate of interest is the price a borrower must pay to secure scarce
loanable funds. It is the price of credit
Financial system provides a variety of interest rates.
Higher interest rates send a price signal to increase savings &
lending but decrease borrowings & investments
Lower interest rates send a price signal to decrease savings &
lending but increase borrowings & investments.
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Introduction
Savings Borrowings
& Financial System &
Lending (Interactions) Investment
The interactions in the Financial System determines the cost of credits (or interest
rates)
[This influences savings & lending, on one hand, and borrowings & investment, on
the other]
Interest Rate Money Cost of Borrowing Funds
(Cost of Credit) Amount of Money Actually Borrowed
3.2. Functions of the Interest Rate in the Economy
The interest rate helps guarantee that current savings will flow into investment to
promote economic growth.
It rations the available supply of credit, generally providing loanable funds to
those investment projects with the highest return.
It brings the supply of money into balance with the public’s demand for money.
It serves as an important tool for government policy through its influence on the
volume of savings and investment.
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3.3. The Theory of Interest Rates
There are several theories of interest rates and their implications in the financial
system. Among these theories, the following four are the common and as well
popular ones as believed by economists and financial analysts:
1. The Classical Theory of Interest Rates
2. The Liquidity Preference Theory of Interest Rates
3. The Loanable Funds Theory of Interest Rates
4. The Rational Expectations Theory of Interest Rates
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1. The Classical Theory of Interest Rates
The classical theory argues that the rate of interest is determined by
two forces:
1. The supply of savings, derived mainly from households, and
2. The demand for investment coming mainly from the business
sector.
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The Classical Theory of Interest Rates
1. Household Savings
Current household savings equal the difference between current income and
current consumption expenditures.
Individuals prefer current over future consumption, and the payment of interest
is a reward for waiting.
Higher interest rates encourage the substitution of current saving for current
consumption.
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The Classical Theory of Interest Rates
The effect relating Savings and Interest Rates
Interest
Rate
r1
Current
S1 Saving
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The Classical Theory of Interest Rates
2. Business and Government Savings
Most businesses hold savings balances in the form of retained earnings.
The amount of which is determined principally by business profits.
Income flows in the economy and the pacing of government spending programs
are the dominant factors affecting government savings (budget surplus).
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The Classical Theory of Interest Rates
The Demand for Investment Funds
Gross business investment equals the sum of replacement investment and net
investment.
The investment decision-making process typically involves the calculation of a
project’s expected internal rate of return, and the comparison of that expected
return with the anticipated returns of alternative projects, as well as with market
interest rates.
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The internal rate of return (r) equates the total cost of an investment project
with the future net cash flows (NCF) expected from that project discounted
back to their present values.
© 2006 by Nelson, a division of Thomson Canada Limited
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The Classical Theory of Interest Rates
The Cost of Capital and the Investment Decision
Expected Internal Rates
of Return on Alternative A – acceptable
Investment Projects 15%
B – acceptable
Cost of Capital
12% C – indifferent Funds = 10%
10% D
unprofitable E
8%
unprofitable 7%
Dollar Cost of Investment Projects
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The Classical Theory of Interest Rates
The Investment Demand Schedule In the Classical Theory of Interest
Rates
r2
I2
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The Classical Theory of Interest Rates
The Equilibrium Rate of Interest in the Classical Theory of Interest Rates
Interest
Rate Investment Savings
rE
Savings &
QE Investment
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The Classical Theory of Interest Rates
Limitations
Factors other than savings and investment that affect interest rates are ignored.
E.g. many financial institutions can “create” money today by making loans to
the public.
Today, economists recognize that income is more important than interest rates
in determining the volume of savings.
In addition to the business sector, both consumers and governments are also
important borrowers today.
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2. The Liquidity Preference (Cash Balances) Theory of Interest
Rates
The demand for liquidity stems from:
The transactions motive - the purchase of goods and services
The precautionary motive - to cope with future emergencies and
extraordinary expenses
The speculative motive - a rise in interest rates results in lower bond prices
and depend on the level of national income, business sales, and prices
(but not interest rates). So, DD due to and is fixed in the short term
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The Total Demand for Money or Cash Balances in the Economy
Interest
Rate : Transactions demand
Total Demand
: Precautionary DD
=++
: Speculative demand
r
+
Quantity of Money /
K Q Cash Balances
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In modern economies, the money supply is controlled, or at least
closely regulated, by the government.
The supply of money (cash balances) is often assumed to be inelastic
with respect to interest rates, since government decisions concerning
the size of the money supply should presumably be guided by public
welfare.
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The Equilibrium Interest Rate in the Liquidity Preference Theory
Interest
Rate Money
Supply
rE Total
Demand
Quantity of
Money / Cash
Balances
QE
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Limitations of the liquidity preference (cash balances)
It is a short-term approach.
In the longer term, the assumption that income remains stable does not
hold.
Only the supply and demand for money is considered.
A more comprehensive view that considers the supply and demand for
credit by all actors in the financial system: businesses, households, and
government is needed.
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[Link] Loanable Funds Theory of Interest
The popular loanable funds theory argues that the risk-free interest rate is
determined by the interplay of two forces:
The demand for credit (loanable funds) by domestic businesses,
consumers, and governments, as well as foreign borrowers
The supply of loanable funds from domestic savings, dishoarding of
money balances, money creation by the banking system, as well as
foreign lending
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Cont’d…
The Demand for Loanable Funds
Consumer (household) dd is relatively inelastic with respect to the IR
Domestic business demand increases as the rate of interest falls.
Government demand does not depend significantly upon the level of IR
Foreign demand is sensitive to the spread between domestic and foreign
interest rates.
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Cont’d…
Total Demand for Loanable Funds (Credit)
Interest
Rate
Total Demand = Dconsumer + Dbusiness +
Dgovernment + Dforeign
Amount of
Loanable Funds
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Cont’d…
The Supply of Loanable Funds
Domestic Savings.
The net effect of income, substitution, and wealth effects is a relatively
interest-inelastic supply of savings curve.
Dishoarding of Money Balances.
When individuals and businesses dispose of their excess cash holdings,
the supply of loanable funds available to others is increased
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Cont’d…
The Supply of Loanable Funds
Creation of Credit by the Domestic Banking System.
Commercial banks and nonbank thrift institutions offering
payments accounts can create credit by lending and investing their
excess reserves.
Foreign lending is sensitive to the spread between domestic and
foreign interest rates.
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Cont’d…
Total Supply of Loanable Funds (Credit)
Interest
Rate Total Supply
= domestic savings
+ newly created money
+ foreign lending
– hoarding demand
Amount of Loanable
Funds
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Cont’d…
The Equilibrium Interest Rate
Interest
Rate Supply
rE
Demand
Amount of
QE Loanable Funds
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At equilibrium:
Planned savings = planned investment across the whole economic system
Money supply = money demand
Supply of loanable funds = demand for loanable funds
Net foreign demand for loanable funds = net exports
IR will be stable only when the economy, money market, loanable funds
market, and foreign currency markets are simultaneously in equilibrium.
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4. The Rational Expectations Theory of Interest
The rational expectations theory builds on a growing body of
research evidence that the money and capital markets are highly
efficient in digesting new information that affects interest rates and
security prices.
The public forms rational and unbiased expectations about the
future demand and supply of credit, and hence interest rates.
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Cont’d…
Interest
Rate Expected Supply
rE
Expected Demand
Amount of
QE Loanable Funds
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Cont’d…
If the money and capital markets are highly efficient, then I/R will
always be very near their equilibrium levels, and the optimal forecast
of next period’s interest rate is the current interest rate.
Interest rates will change only if entirely new and unexpected
information appears, and the direction of change depends on the
public’s current set of expectations.
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Limitations of the rational expectations theory of interest
At the moment, we do not know very much about how the public
forms its expectations.
The cost of gathering and analyzing information relevant to the
pricing of assets is not always negligible, as assumed.
Not all interest rates and security prices appear to display the kind of
behavior implied by the rational expectations theory.
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re e
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