Tài chính doanh nghiệp - Chapter 2: Determination of interest rates

Chapter 2Determination of Interest RatesFinancial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.1Chapter OutlineLoanable funds theoryEconomic forces that affect interest ratesForecasting interest rates2Loanable Funds TheoryLoanable funds theory suggests that the market interest rate is determined by the factors that affect the supply of and demand for loanable fundsCan be used to explain movements in the general level of interest rates of a particular countryCan be used to explain why interest rates among debt securities of a given country vary3Loanable Funds Theory (cont’d)Household demand for loanable fundsHouseholds demand loanable funds to financeHousing expendituresAutomobilesHousehold itemsThere is an inverse relationship between the interest rate and the quantity of loanable funds demanded4Loanable Funds Theory (cont’d)Business demand for loanable fundsBusinesses demand loanable funds to invest in fixed assets and short-term assetsBusinesses evaluate projects using net present value (NPV):Projects with a positive NPV are acceptedThere is an inverse relationship between interest rates and business demand for loanable funds5Loanable Funds Theory (cont’d)Government demand for loanable fundsGovernments demand funds when planned expenditures are not covered by incoming revenuesMunicipalities issue municipal bondsThe federal government issues Treasury securities and federal agency securitiesGovernment demand for loanable funds is interest-inelastic6Loanable Funds Theory (cont’d)Foreign Demand for loanable fundsForeign demand for U.S. funds is influenced by the interest rate differential between countriesThe quantity of U.S. loanable funds demanded by foreign governments or firms is inversely related to U.S. interest ratesThe foreign demand schedule will shift in response to economic conditions7Loanable Funds Theory (cont’d)Aggregate demand for loanable fundsThe sum of the quantities demanded by the separate sectors at any given interest rate is the aggregate demand for loanable funds8Loanable Funds Theory (cont’d)DhHousehold DemandDbBusiness Demand9Loanable Funds Theory (cont’d)DgFederal Government DemandDmMunicipal Government Demand10Loanable Funds Theory (cont’d)DfForeign Demand11Loanable Funds Theory (cont’d)DAAggregate Demand12Loanable Funds Theory (cont’d)Supply of loanable fundsFunds are provided to financial markets byHouseholds (net suppliers of funds)Government units and businesses (net borrowers of funds)Suppliers of loanable funds supply more funds at higher interest rates13Loanable Funds Theory (cont’d)Supply of loanable funds (cont’d)Foreign households, governments, and corporations supply funds by purchasing Treasury securitiesForeign households have a high savings rateThe supply is influenced by monetary policy implemented by the Federal Reserve SystemThe Fed controls the amount of reserves held by depository institutionsThe supply curve can shift in response to economic conditionsHouseholds would save more funds during a strong economy14Loanable Funds Theory (cont’d)SAAggregate Supply15Loanable Funds Theory (cont’d)Equilibrium interest rate - algebraicThe aggregate demand can be written asThe aggregate supply can be written as16Loanable Funds Theory (cont’d)SAEquilibrium Interest Rate - GraphicDAi17Economic Forces That Affect Interest RatesEconomic growthShifts the demand schedule outward (to the right)There is no obvious impact on the supply scheduleSupply could increase if income increases as a result of the expansionThe combined effect is an increase in the equilibrium interest rate18Loanable Funds Theory (cont’d)SAImpact of Economic ExpansionDAiDA2i219Economic Forces That Affect Interest Rates (cont’d)InflationShifts the supply schedule inward (to the left)Households increase consumption now if inflation is expected to increaseShifts the demand schedule outward (to the right)Households and businesses borrow more to purchase products before prices rise20Loanable Funds Theory (cont’d)SAImpact of Expected Increase in InflationDAiDA2i2SA221Economic Forces That Affect Interest Rates (cont’d)Fisher effectNominal interest payments compensate savers for:Reduced purchasing powerA premium for forgoing present consumptionThe relationship between interest rates and expected inflation is often referred to as the Fisher effect22Economic 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:23Economic Forces That Affect Interest Rates (cont’d)Money supplyIf the Fed increases the money supply, the supply of loanable funds increasesIf inflationary expectations are affected, the demand for loanable funds may also increaseIf the Fed reduces the money supply, the supply of loanable funds decreasesDuring 2001, the Fed increased the growth of the money supply several times24Economic Forces That Affect Interest Rates (cont’d)Money supply (cont’d)September 11Firms cut back on expansion plansHouseholds cut back on borrowing plansThe demand of loanable funds declinedThe weak economy in 2001–2002Reduced demand for loanable fundsThe Fed increased the money supply growthInterest rates reached very low levels25Economic Forces That Affect Interest Rates (cont’d)Budget deficitA high deficit means a high demand for loanable funds by the governmentShifts the demand schedule outward (to the right)Interest rates increaseThe government may be willing to pay whatever is necessary to borrow funds, but the private sector may notCrowding-out effectThe supply schedule may shift outward if the government creates more jobs by spending more funds than it collects from the public26Economic Forces That Affect Interest Rates (cont’d)Foreign flows of fundsThe interest rate for a currency is determined by the demand for and supply of that currencyImpacted by the economic forces that affect the equilibrium interest rate in a given country, such as:Economic growthInflationShifts in the flows of funds between countries cause adjustments in the supply of funds available in each country27Economic Forces That Affect Interest Rates (cont’d)Explaining the variation in interest rates over timeLate 1970s: high interest rates as a result of strong economy and inflationary expectationsEarly 1980s: recession led to a decline in interest ratesLate 1980s: interest rates increased in response to a strong economyEarly 1990s: interest rates declined as a result of a weak economy1994: interest rates increased as economic growth increasedDrifted lower for next several years despite strong economic growth, partly due to the U.S. budget surplus28Forecasting Interest RatesIt is difficult to predict the precise change in the interest rate due to a particular eventBeing able to assess the direction of supply or demand schedule shifts can help in understanding why rates changed29Forecasting Interest Rates (cont’d)To forecast future interest rates, the net demand for funds (ND) should be forecast:30Forecasting Interest Rates (cont’d)A positive disequilibrium in ND will be corrected by an increase in interest ratesA negative disequilibrium in ND will be corrected by a decrease in interest rates31