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Chapter 2
Determination of Interest Rates
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
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Chapter Outline

Loanable funds theory

Economic forces that affect interest rates

Forecasting interest rates
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Loanable Funds Theory

Loanable funds theory suggests that the
market interest rate is determined by the factors
that affect the supply of and demand for loanable
funds

Can be used to explain movements in the general
level of interest rates of a particular country

Can be used to explain why interest rates among debt
securities of a given country vary
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Loanable Funds Theory (cont’d)

Household demand for loanable funds

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Loanable Funds Theory (cont’d)

Government demand for loanable funds

Governments demand funds when planned expenditures are not
covered by incoming revenues

Municipalities issue municipal bonds

The federal government issues Treasury securities and
federal agency securities

Government demand for loanable funds is interest-inelastic
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Loanable Funds Theory (cont’d)

Foreign Demand for loanable funds

Foreign demand for U.S. funds is influenced by the interest rate
differential between countries


Loanable Funds Theory (cont’d)
D
f
Foreign Demand
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Loanable Funds Theory (cont’d)
D
A
Aggregate Demand
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Loanable Funds Theory (cont’d)

Supply of loanable funds

Funds are provided to financial markets by

Households (net suppliers of funds)

Government units and businesses (net borrowers of funds)

Suppliers of loanable funds supply more funds at higher interest
rates
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Loanable Funds Theory (cont’d)

Supply of loanable funds (cont’d)

Foreign households, governments, and corporations
supply funds by purchasing Treasury securities


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Loanable Funds Theory (cont’d)
S
A
Equilibrium Interest Rate - Graphic
D
A
i
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Economic Forces That Affect
Interest Rates

Economic growth

Shifts the demand schedule outward (to the right)

There is no obvious impact on the supply schedule

Supply could increase if income increases as a result of the
expansion

The combined effect is an increase in the equilibrium interest
rate
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Loanable Funds Theory (cont’d)
S
A
Impact of Economic Expansion
D
A

i
2
S
A2
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Economic Forces That Affect
Interest Rates (cont’d)

Fisher effect

Nominal interest payments compensate savers for:

Reduced purchasing power

A premium for forgoing present consumption

The relationship between interest rates and expected inflation is
often referred to as the Fisher effect
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Economic Forces That Affect
Interest Rates (cont’d)

Fisher effect (cont’d)

Fisher effect equation:

The difference between the nominal interest rate
and the expected inflation rate is the real
interest rate:
R


Households cut back on borrowing plans

The demand of loanable funds declined

The weak economy in 2001–2002

Reduced demand for loanable funds

The Fed increased the money supply growth

Interest rates reached very low levels