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CHAPTER 2

Determination of Interest Rates

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CHAPTER 2 OVERVIEW

This chapter will:

A. Apply loanable funds theory to explain why interest rates change

B. Identify the most relevant factors that affect interest rate movements

C. Explain how to forecast interest rates

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A. Loanable Funds Theory

1. Household DemandThere exists an inverse relationship between the interest rate and the quantity of loanable funds demanded.

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A. Loanable Funds Theory

2. Business Demandbusinesses will demand a greater quantity of loanable funds at lower interest rates

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A. Loanable Funds Theory

3. Government Demandexpenditures and tax policies

independent of the level of interest rates or interest-inelastic

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A. Loanable Funds Theory

4. Foreign Demand for Loanable Funds

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A. Loanable Funds Theory

5. Determinants of the Supply of Loanable Funds

a. suppliers more willing to supply at higher rates

b. U.S. supply is influenced by the Federal Reserve

c. Tax rates on interest income affect the level of supply

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A. Loanable Funds Theory

6. Equilibrium Interest Rates

a. In equilibrium:

where

DA = the aggregate demand for loanable funds

SA = the aggregate supply for loanable funds

AA SD

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B. Economic Forces that Affect Interest Rates

1. Impact of Economic Growth on Interest Rates

a. Slowdown in growth: demand schedule shifts to left (demand

decreases) supply schedule may shift

b. Increase in growth: Puts pressure on interest rates to rise

due to increase in the demand schedule

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B. Economic Forces that Affect Interest Rates

2. Impact of Inflation on Interest Rates

a. Fisher Effect:

states that the real rate of interest is the nominal rate less the expected inflation rate.

b. The greater the expected rate of inflation, the greater the

nominal rate of interest.

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B. Economic Forces that Affect Interest Rates

3. Impact of the Budget Deficit on Interest Rates

“Crowding-out” Effect:

Given a certain amount of loanable funds supplied to the market, excessive

government demand for funds tends to “crowd out” the private demand for

funds.

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B. Economic Forces that Affect Interest Rates

4. Impact of Foreign Flows of Funds on Interest Rates

In recent years, massive flows of funds have shifted between countries causing abrupt shifts in the supply of loanable funds.

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C. Forecasting Interest Rates

1. Future Demand for Loanable Funds depends on future

a. Foreign demand for U.S. funds

b. Household demand for funds

c. Business demand for funds

d. Government demand for funds

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C. Forecasting Interest Rates

2. Future Supply of Loanable Funds depends on:

a. Future supply by households and others

b. Future foreign supply of loanable funds in the U.S.

Homework Assignment 1

Textbook Q&A: 3,4,5,6,11 What is the trend of the US interest rate over the past

20 years? What is your prediction for the next year? Why?

We observed an increasing large budget deficit over the past several years. Obviously, there is a large demand for funds. But interest rates however have been lower. Why? What could be the potential reasons and factors?

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