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CHAPTER 2

Determination of Interest Rates

A. Loanable Funds Theory

Determinants of the Demand for Loanable Funds

Household Demand for Loanable Funds inverse relationship between the interest rate and the

quantity of loanable funds demanded.

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A. Loanable Funds Theory

Determinants of the Demand for Loanable Funds Business Demand for Loanable Funds

businesses will demand a greater quantity of loanable funds at lower interest rates

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A. Loanable Funds Theory

Determinants of the Demand for Loanable Funds Government Demand for Loanable Funds

expenditures and tax policies are independent of the level of interest rates or are interest-inelastic

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A. Loanable Funds Theory

Foreign Demand for Loanable Funds Depends on the interest rate differential

between two countries. The greater the differential, the greater the

demand.

The quantity of U.S. loanable funds demanded by foreign governments will be inversely related to U.S. interest rates.

Exhibit 2.4 Impact of Increased Foreign Interest Rates on the Foreign Demand for U.S. Loanable Funds

Exhibit 2.5 Determination of the Aggregate Demand Schedule for Loanable Funds

Exhibit 2.6 Aggregate Supply Schedule for Loanable Funds

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A. Loanable Funds Theory

Determinants of the Supply of Loanable Funds Suppliers more willing to supply at higher

rates U.S. supply is influenced by the Federal

Reserve Tax rates on interest income affect the level of

supply

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A. Loanable Funds Theory

Equilibrium Interest Rates

In equilibrium:

where

DA = the aggregate demand for loanable funds

SA = the aggregate supply for loanable funds

AA SD

Exhibit 2.7 Interest Rate Equilibrium

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B. Economic Forces that Affect Interest Rates

Impact of Economic Growth on Interest Rates Slowdown in growth:

demand decreases (shifts left) supply schedule may shift but very little

Exhibit 2.9 Impact of an Economic Slowdown

Economic Forces that Affect Interest RatesImpact of Economic Growth on Interest Rates Increase in growth:

Puts pressure on interest rates to rise due to increase in the demand schedule

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Exhibit 2.8 Impact of Increased Expansion by Firms

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B. Economic Forces that Affect Interest RatesImpact of Inflation on Interest Rates

– Fisher Effect: the real rate of interest is the difference between the nominal rate and the expected inflation rate.

The greater the expected rate of inflation, the greater the nominal rate of interest.

)(INFEiiR

Exhibit 2.10 Impact of an Increase in Inflationary Expectations on Interest Rates

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B. Economic Forces that Affect Interest Rates

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

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

Future Demand for Loanable Funds depends on: Future Foreign demand for U.S. funds Future Household demand for funds Future Business demand for funds Future Government demand for funds

Future Supply of Loanable Funds depends on: Future supply by households and others Future foreign supply of loanable funds in the

U.S.

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Practice Problems

2,3,4,6,7,8, Interpreting Financial News