CHAPTER 2
INTEREST RATE
DETERMINATION
By: Melese Mulu
April 26, 2023
DEFINITION OF INTEREST RATE
Is a percentage reward a lender receives for deferring the
consumption of resources for the future.
It measures the price a borrower pays to have resources
now.
The higher the interest rate, the more valuable is money
today and the lower is the present value of money in the
future.
Interest is income earned on the funds utilized by the
DETERMINANTS OF MAGNITUDE OF INTEREST RATE
The strength of the economy and the willingness to save:
Willingness of consumers, businesses, and governments to save and
invest determine the magnitude of interest rate. In a strong economy,
investment is high which influences interest rate.
The rate of inflation:
In an economy where inflation is high, interest rate should be high to
compensate for this inflation. The lending interest rate should include the
existing inflation rate.
DETERMINANTS OF MAGNITUDE OF INTEREST RATE
The tax treatment of the interest:
The lower the tax rate, the more consumers are would be
willing to lend at lower interest rate.
The time period of the loan: The longer the maturity of
loan, the higher the interest rate charged.
METHODS OF CALCULATING INTEREST RATE
Simple interest:
It is a simpler form of computing interest on the principal amount as the term of the
loan is considered for that year only, and interest is charged or provided every year on
the same original sum deposited or lent.
PRT (Principal*Interest rate * Time). For example, if the original principal amount is
$100 and the interest rate is 10% per annum for one year, interest is 100*10%*1 = 10.
Compound interest:
Considers the time value of money.
It charges interest on interest income and principal.
This method was first introduced in Italy in the 17 th century.
THE LEVEL OF INTEREST RATE
Theories:
Marxist Theory: interest rate is the transformation of surplus
value, is essentially a part of profits.
The premise of interest generation is the division of capital
ownership and the right of using capital.
THE LEVEL OF INTEREST RATE
Theories:
Marxist Theory:
The amount of interest is determined by total profit while the interest rate, which is
determined by average profit rate, falls between average profit rates and zero.
Interest rates are determined by both the profit rate and the distribution proportion of
total profits between the lender and the borrower.
THE LEVEL OF INTEREST RATE
Classical Theory:
Bohm-Bawerk: defines interest as value differences which result from different
evaluation of goods in different periods; therefore, the theory is known as the ‘Time
Preference Theory’ in which goods are sorted into two categories: “present goods” and
“future goods”.
The subjective evaluation of the same goods with the same quality and quantity is
different at the present time and in the future.
THE LEVEL OF INTEREST RATE
Classical Theory:
Bohm-Bawerk:
Normally, present goods have a greater value than future
goods of the same quality and quantity, and the difference
between the two is the value of time.
Interest is a kind of compensation for time value.
THE LEVEL OF INTEREST RATE
Classical Theory:
Fisher argues that interest is a discount generated in the exchange between present goods
and future goods and is determined by both subjective and objective factors.
The subjective factor is people’s time preference for present goods.
The exchange of present and future goods is realized through transactions in the money
market and securities market. In this process of exchange, people’s time preference
determines interest rates.
THE LEVEL OF INTEREST RATE
Classical Theory:
Fisher:
The objective factor refers to possible investment opportunities. Entrepreneurs would
consider the level of interest rates in their investment decisions.
People’s time preference determines money supply while entrepreneurs’ choice of
investment opportunities determines money demand, and the equilibrium interest rate thus
is determined by the consistency of these two choices.
THE LEVEL OF INTEREST RATE
Classical Theory:
Marshall holds that interest rates are the compensation for waiting (savings),
and are determined by capital supply and demand.
Capital supply (savings) moves in the same direction as interest rates
whereas capital demand (investment) is negatively correlated with interest
rates. The demand and supply of capital determines interest rates.
THE LEVEL OF INTEREST RATE
Classical Theory:
Marshall:
The restraints of present consumption and the wait for future rewards
determine the supply of capital.
Capital demand depends on investment opportunities and return. Generally
speaking, interest rates rise when investments exceed savings that results in
short of capital, and vice versa.
The interaction between savings and investments determines the interest rate
level. In fact, savings and investments themselves are affected by interest rates
as well.
BOND PRICES AND INTEREST RATE RISK
These two variables move in an opposite direction
THE STRUCTURE OF INTEREST RATE
structure of interest rate refers to the relationship between interest rates (bond yields) and its
maturities.
Useful to valuing bonds.
Its graphical representation is called yield curve.
It is a fundamental approach to identify the state (performance) of a given economy.
It shows the behaviors of market agents in relation to the future changes in interest rate.
The tool also helps to understand the reaction of agents to monetary policy.
THE STRUCTURE OF INTEREST RATE
structure of interest rate is determined by the operation of the capital market.
But the operation of the capital market maybe influenced by monetary policies and the
reaction of buyers and sellers of financial securities.
The term structure of interest rates refers to the relationship between
bonds of different terms.
THE STRUCTURE OF INTEREST RATE
A normal yield curve is positively sloped as investors require more yield for longer maturity
bonds.
However, this is not always the case.
Yield curve has different shapes that reflects investors attitude towards the future conditions
of an economy.
That is why careful observation of the shape of the yield curve is crucial.
THE STRUCTURE OF INTEREST RATE
The essence of the three shapes of a yield curve:
• Upward sloping:
• long-term yields are higher than short-term yields.
• This is considered to be the "normal" slope of the yield curve
-and signals that the economy is in an expansionary mode.
-steeper yield curve-strong economic growth in the future.
THE STRUCTURE OF INTEREST RATE
The essence of the three shapes of a yield curve:
• Downward sloping—short-term yields are higher than long-term yields.
• Dubbed as an "inverted" yield curve and signifies that-
the economy is in, or about to enter, a recessive period.
THE STRUCTURE OF INTEREST RATE
The essence of the three shapes of a yield curve:
• Flat:
• very little variation between short and long-term yields.
• This signals that the market is
-unsure about the future direction of the economy.
PRESENTATION TOPICS
• Theories of term structure of interest rates
• Role of term structure of interest rates in Monetary policy