1 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. 2 Chapter Outline  Loanable funds theory  Economic forces that affect interest rates  Forecasting interest rates 3 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 4 Loanable Funds Theory (cont’d)  Household demand for loanable funds  Households demand loanable funds to finance  Housing expenditures  Automobiles  Household items  There is an inverse relationship between the interest rate and the quantity of loanable funds demanded 5 Loanable Funds Theory (cont’d)  Business demand for loanable funds  Businesses demand loanable funds to invest in fixed assets and short-term assets  Businesses evaluate projects using net present value (NPV):  Projects with a positive NPV are accepted  There is an inverse relationship between interest rates and business demand for loanable funds ∑ = + +−= n t t t k CF INVNPV 1 )1( 6 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 7 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  The quantity of U.S. loanable funds demanded by foreign governments or firms is inversely related to U.S. interest rates  The foreign demand schedule will shift in response to economic conditions 8 Loanable Funds Theory (cont’d)  Aggregate demand for loanable funds  The sum of the quantities demanded by the separate sectors at any given interest rate is the aggregate demand for loanable funds 9 Loanable Funds Theory (cont’d) D h Household Demand D b Business Demand 10 Loanable Funds Theory (cont’d) D g Federal Government Demand D m Municipal Government Demand [...]... Rates (cont’d)  Money supply (cont’d)   September 11  Firms cut back on expansion plans  Households cut back on borrowing plans  The demand of loanable funds declined The weak economy in 2001–2 002  Reduced demand for loanable funds  The Fed increased the money supply growth  Interest rates reached very low levels 25 Economic Forces That Affect Interest Rates (cont’d)  Budget deficit  A high . 1 Chapter 2 Determination of Interest Rates Financial Markets and Institutions,. ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 2 Chapter Outline  Loanable funds theory  Economic forces that affect interest