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Theories of interest ratesTheories of interest rates

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Learning Objectives To understand the important roles and

functions that interest rates perform within the economy and the financial system.

To explore the most important ideas about the determinants of interest rates and asset prices.

To identify the key forces that economists believe set market interest rates and asset prices into motion.

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Introduction

The acts of saving and lending, and borrowing and investing, are significantly influenced by and tied together by the interest rate.

The interest rate is the price a borrower must pay to secure scarce loanable funds from a lender for an agreed-upon time period.

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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.

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Functions of the Interest Rate in the Economy

The interest rate serves as an important tool for government policy through its influence on the volume of savings and investment.

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The Classical Theory of Interest Rates

The classical theory argues that the rate of interest is determined by two forces:the supply of savings, derived mainly

from households, andthe demand for investment capital,

coming mainly from the business sector.

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Household SavingsCurrent 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 Substitution EffectRelating Savings and Interest Rates

InterestRate

CurrentSaving

r1

S1

r2

S2

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Business and Government SavingsMost businesses hold savings balances in

the form of retained earnings, the amount of which is determined principally by business profits, and to a lesser extent, by interest rates.

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 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 Investment Demand ScheduleIn the Classical Theory of Interest Rates

r2

InterestRate

InvestmentSpending

r1

I1I2

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The Equilibrium Rate of InterestIn the Classical Theory of Interest Rates

InterestRate

Savings &Investment

rE

QE

Investment Savings

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LimitationsFactors other than savings and investment

that affect interest rates are ignored. For example, 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.

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In addition to the business sector, both consumers and governments are also important borrowers today.

Limitations …

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The Liquidity Preference (Cash Balances) Theory of Interest Rates

The liquidity preference (or cash balances) theory of interest rates is a short-term theory that was developed for explaining near-term changes in interest rates, and hence, is more relevant for policymakers.

According to the theory, the rate of interest is the payment to money (cash balances) holders for the use of their scarce resource (liquidity), by those who demand liquidity (i.e. money or cash balances).

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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 higher demand for bonds, hence lower demand for liquidity.

and depend on the level of national income, business sales, and prices (but not interest rates). So, demand due to and is fixed in the short term.

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The Total Demand for Money or Cash Balancesin the Economy

InterestRate

Quantity ofMoney / Cash

Balances

r

Total Demand= + +

Q

+

: transactions demand

: precautionary demand

: speculative demand

K

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The Money MarketInterest

Rate

Quantity of Money

Money Supply

QFixed

If the RBI buys government

bonds, money supply

increases.

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The Money MarketInterest

Rate

Quantity of Money

Money Supply

QFixed

If the RBI sells government

bonds, money supply

decreases.

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The Equilibrium Interest RateIn the Liquidity Preference Theory

InterestRate

Quantity ofMoney / Cash

Balances

rE TotalDemand

QE

MoneySupply

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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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Limitations The liquidity preference theory 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 governments - is needed.

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The Loanable Funds Theory of InterestThe 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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The Loanable Funds Theory of Interest

The Demand for Loanable FundsConsumer (household) demand is relatively

inelastic with respect to the rate of interest.Domestic business demand increases as the

rate of interest falls.Government demand does not depend

significantly upon the level of interest rates.Foreign demand is sensitive to the spread

between domestic and foreign interest rates.

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Total Demand for Loanable Funds (Credit)

InterestRate

Amount ofLoanable Funds

Total Demand

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The Supply of Loanable FundsDomestic 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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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.

The Supply of Loanable Funds …

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Total Supply of Loanable Funds (Credit)

InterestRate


Total Supply = domestic savings +

newly created money + foreign lending – hoarding demand

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The Equilibrium Interest Rate

InterestRate


rE

QE

Demand

Supply

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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

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Interest rates will be stable only when the economy, money market, loanable funds market, and foreign currency markets are simultaneously in equilibrium.

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