Textbook Problems
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FinancialInstitutionsCht2.docx2 Determination of Interest Rates
CHAPTER OBJECTIVES
The specific objectives of this chapter are to:
· ▪ apply the loanable funds theory to explain why interest rates change,
· ▪ identify the most relevant factors that affect interest rate movements, and
· ▪ explain how to forecast interest rates.
An interest rate reflects the rate of return that a creditor receives when lending money, or the rate that a borrower pays when borrowing money. Since interest rates change over time, so does the rate earned by creditors who provide loans or the rate paid by borrowers who obtain loans. Interest rate movements have a direct influence on the market values of debt securities, such as money market securities, bonds, and mortgages. They have an indirect influence on equity security values because they can affect the return by investors who invest in equity securities. Thus, participants in financial markets attempt to anticipate interest rate movements when restructuring their investment or loan positions.
Interest rate movements also affect the value of most financial institutions. They influence the cost of funds to depository institutions and the interest received on some loans by financial institutions. Since many financial institutions invest in securities (such as bonds), the market value of their investments is affected by interest rate movements. Thus managers of financial institutions attempt to anticipate interest rate movements and commonly restructure their assets and liabilities to capitalize on their expectations. Individuals attempt to anticipate interest rate movements so that they can monitor the potential cost of borrowing or the potential return from investing in various debt securities.
2-1 LOANABLE FUNDS THEORY
WEB
Information on interest rates in recent months.
The loanable funds theory , commonly used to explain interest rate movements, suggests that the market interest rate is determined by factors controlling the supply of and demand for loanable funds. The theory is especially useful for explaining movements in the general level of interest rates for a particular country. Furthermore, it can be used (along with other concepts) to explain why interest rates among some debt securities of a given country vary, which is the focus of the next chapter. The phrase “demand for loanable funds” is widely used in financial markets to refer to the borrowing activities of households, businesses, and governments. This chapter describes the sectors that commonly affect the demand for loanable funds and then describes the sectors that supply loanable funds to the markets. Finally, the demand and supply concepts are integrated to explain interest rate movements.
Exhibit 2.1 Relationship between Interest Rates and Household Demand (Dh) for Loanable Funds at a Given Point in Time
2-1a Household Demand for Loanable Funds
Households commonly demand loanable funds to finance housing expenditures. In addition, they finance the purchases of automobiles and household items, which results in installment debt. As the aggregate level of household income rises, so does installment debt. The level of installment debt as a percentage of disposable income has been increasing over time, although it is generally lower in recessionary periods.
If households could be surveyed at any given time to indicate the quantity of loanable funds they would demand at various interest rate levels, the results would reveal an inverse relationship between the interest rate and the quantity of loanable funds demanded. This simply means that, at any moment in time, households would demand a greater quantity of loanable funds at lower rates of interest; in other words, they are willing to borrow more money (in aggregate) at lower rates of interest.
EXAMPLE
Consider the household demand-for-loanable-funds schedule (also called the demand curve) in Exhibit 2.1 , which shows how the amount of funds that would be demanded is dependent on the interest rate. Various events can cause household borrowing preferences to change and thereby shift the demand curve. For example, if tax rates on household income are expected to decrease significantly in the future, households might believe that they can more easily afford future loan repayments and thus be willing to borrow more funds. For any interest rate, the quantity of loanable funds demanded by households would be greater as a result of the tax rate change. This represents an outward shift (to the right) in the demand curve.
2-1b Business Demand for Loanable Funds
Businesses demand loanable funds to invest in long-term (fixed) and short-term assets. The quantity of funds demanded by businesses depends on the number of business projects to be implemented. Businesses evaluate a project by comparing the present value of its cash flows to its initial investment, as follows:
where
· NPV = net present value of project
· INV = initial investment
· CF t = cash flow in period t
· k = required rate of return on project
Projects with a positive net present value (NPV) are accepted because the present value of their benefits outweighs the costs. The required return to implement a given project will be lower if interest rates are lower because the cost of borrowing funds to support the project will be lower. Hence more projects will have positive NPVs, and businesses will need a greater amount of financing. This implies that, all else being equal, businesses will demand a greater quantity of loanable funds when interest rates are lower; this relation is illustrated in Exhibit 2.2 .
In addition to long-term assets, businesses also need funds to invest in their short-term assets (such as accounts receivable and inventory) in order to support ongoing operations. Any demand for funds resulting from this type of investment is positively related to the number of projects implemented and thus is inversely related to the interest rate. The opportunity cost of investing in short-term assets is higher when interest rates are higher. Therefore, firms generally attempt to support ongoing operations with fewer funds during periods of high interest rates. This is another reason that a firm's total demand for loanable funds is inversely related to prevailing interest rates. Although the demand for loanable funds by some businesses may be more sensitive to interest rates than others, all businesses are likely to demand more funds when interest rates are lower.
Shifts in the Demand for Loanable Funds The business demand-for-loanable funds schedule (as reflected by the demand curve in Exhibit 2.2 ) can change in reaction to any events that affect business borrowing preferences. If economic conditions become more favorable, the expected cash flows on various proposed projects will increase. More proposed projects will then have expected returns that exceed a particular required rate of return (sometimes called the hurdle rate). Additional projects will be acceptable as a result of more favorable economic forecasts, causing an increased demand for loanable funds. The increase in demand will result in an outward shift (to the right) in the demand curve.
WEB
Information on the U.S. government's debt.
Exhibit 2.2 Relationship between Interest Rates and Business Demand (Db) for Loanable Funds at a Given Point in Time
2-1c Government Demand for Loanable Funds
Whenever a government's planned expenditures cannot be completely covered by its incoming revenues from taxes and other sources, it demands loanable funds. Municipal (state and local) governments issue municipal bonds to obtain funds; the federal government and its agencies issue Treasury securities and federal agency securities. These securities constitute government debt.
The federal government's expenditure and tax policies are generally thought to be independent of interest rates. Thus the federal government's demand for funds is referred to as interest-inelastic , or insensitive to interest rates. In contrast, municipal governments sometimes postpone proposed expenditures if the cost of financing is too high, implying that their demand for loanable funds is somewhat sensitive to interest rates.
Like household and business demand, government demand for loanable funds can shift in response to various events.
EXAMPLE
The federal government's demand-for-loanable-funds schedule is represented by Dg1 in Exhibit 2.3 . If new bills are passed that cause a net increase of $200 billion in the deficit, the federal government's demand for loanable funds will increase by that amount. In the graph, this new demand schedule is represented by Dg2.
2-1d Foreign Demand for Loanable Funds
The demand for loanable funds in a given market also includes foreign demand by foreign governments or corporations. For example, the British government may obtain financing by issuing British Treasury securities to U.S. investors; this represents British demand for U.S. funds. Because foreign financial transactions are becoming so common, they can have a significant impact on the demand for loanable funds in any given country. A foreign country's demand for U.S. funds (i.e., preference to borrow U.S. dollars) is influenced by, among other factors, the difference between its own interest rates and U.S. rates. Other things being equal, a larger quantity of U.S. funds will be demanded by foreign governments and corporations if their domestic interest rates are high relative to U.S. rates. As a result, for a given set of foreign interest rates, the quantity of U.S. loanable funds demanded by foreign governments or firms will be inversely related to U.S. interest rates.
WEB
Interest rate information.
Exhibit 2.3 Impact of Increased Government Deficit on the Government Demand for Loanable Funds
Exhibit 2.4 Impact of Increased Foreign Interest Rates on the Foreign Demand for U.S. Loanable Funds
The foreign demand curve can shift in response to economic conditions. For example, assume the original foreign demand schedule is represented by Df1 in Exhibit 2.4 . If foreign interest rates rise, foreign firms and governments will likely increase their demand for U.S. funds, as represented by the shift from Df1to Df2.
2-1e Aggregate Demand for Loanable Funds
The aggregate demand for loanable funds is the sum of the quantities demanded by the separate sectors at any given interest rate, as shown in Exhibit 2.5 . Because most of these sectors are likely to demand a larger quantity of funds at lower interest rates (other things being equal), it follows that the aggregate demand for loanable funds is inversely related to the prevailing interest rate. If the demand schedule of any sector changes, the aggregate demand schedule will also be affected.
2-1f Supply of Loanable Funds
The term “supply of loanable funds” is commonly used to refer to funds provided to financial markets by savers. The household sector is the largest supplier, but loanable funds are also supplied by some government units that temporarily generate more tax revenues than they spend or by some businesses whose cash inflows exceed outflows. Yet households as a group are a net supplier of loanable funds, whereas governments and businesses are net demanders of loanable funds.
Suppliers of loanable funds are willing to supply more funds if the interest rate (reward for supplying funds) is higher, other things being equal. This means that the supply-of-loanable-funds schedule (also called the supply curve) is upward sloping, as shown in Exhibit 2.6 . A supply of loanable funds exists at even a very low interest rate because some households choose to postpone consumption until later years, even when the reward (interest rate) for saving is low. Foreign households, governments, and businesses commonly supply funds to their domestic markets by purchasing domestic securities. In addition, they have been a major creditor to the U.S. government by purchasing large amounts of Treasury securities. The large foreign supply of funds to the U.S. market is due in part to the high saving rates of foreign households.
Effects of the Fed The supply of loanable funds in the United States is also influenced by the monetary policy implemented by the Federal Reserve System. The Fed conducts monetary policy in an effort to control U.S. economic conditions. By affecting the supply of loanable funds, the Fed's monetary policy affects interest rates (as will be described shortly). By influencing interest rates, the Fed is able to influence the amount of money that corporations and households are willing to borrow and spend.
Exhibit 2.5 Determination of the Aggregate Demand Curve for Loanable Funds
Exhibit 2.6 Aggregate Supply Curve for Loanable Funds
Aggregate Supply of Funds The aggregate supply schedule of loanable funds represents the combination of all sector supply schedules along with the supply of funds provided by the Fed's monetary policy. The steep slope of the aggregate supply curve in Exhibit 2.6 means that it is interest-inelastic. The quantity of loanable funds demanded is normally expected to be more elastic, meaning more sensitive to interest rates, than the quantity of loanable funds supplied.
The supply curve can shift inward or outward in response to various conditions. For example, if the tax rate on interest income is reduced, then the supply curve will shift outward as households save more funds at each possible interest rate level. Conversely, if the tax rate on interest income is increased, then the supply curve will shift inward as households save fewer funds at each possible interest rate level.
In this section, minimal attention has been given to financial institutions. Although financial institutions play a critical intermediary role in channeling funds, they are not the ultimate suppliers of funds. Any change in a financial institution's supply of funds results only from a change in habits of the households, businesses, or governments that supply those funds.
2-1g Equilibrium Interest Rate
An understanding of equilibrium interest rates is necessary to assess how various events can affect interest rates. In reality, there are several different interest rates because some borrowers pay a higher rate than others. At this point, however, the focus is on the forces that cause the general level of interest rates to change, since interest rates across borrowers tend to change in the same direction. The determination of an equilibrium interest rate is presented first from an algebraic perspective and then from a graphical perspective. Following this presentation, several examples are offered to reinforce the concept.
Algebraic Presentation The equilibrium interest rate is the rate that equates the aggregate demand for funds with the aggregate supply of loanable funds. The aggregate demand for funds (DA) can be written as
DA = Dh + Db + Dg Dm + Df
where
· Dh = household demand for loanable funds
· Db = business demand for loanable funds
· Dg = federal government demand for loanable funds
· Dm = municipal government demand for loanable funds
· Df = foreign demand for loanable funds
The aggregate supply of funds (SA) can likewise be written as
SA = Sh + Sb + Sg + Sm + Sf
where
· Sh =household supply of loanable funds
· Sb =business supply of loanable funds
· Sg =federal government supply of loanable funds
· Sm =municipal government supply of loanable funds
· Sf =foreign supply of loanable funds
In equilibrium, DA = SA. If the aggregate demand for loanable funds increases without a corresponding increase in aggregate supply, there will be a shortage of loanable funds. In this case, interest rates will rise until an additional supply of loanable funds is available to accommodate the excess demand. Conversely, an increase in the aggregate supply of loanable funds without a corresponding increase in aggregate demand will result in a surplus of loanable funds. In this case, interest rates will fall until the quantity of funds supplied no longer exceeds the quantity of funds demanded.
In many cases, both supply and demand for loanable funds are changing. Given an initial equilibrium situation, the equilibrium interest rate should rise when DA > SA and fall when DASA.
Graphical Presentation By combining the aggregate demand and aggregate supply curves of loanable funds (refer to Exhibits 2.5 and 2.6 ), it is possible to compare the total amount of funds that would be demanded to the total amount of funds that would be supplied at any particular interest rate. Exhibit 2.7 illustrates the combined demand and supply schedules. At the equilibrium interest rate of i, the supply of loanable funds is equal to the demand for loanable funds.
At any interest rate above i, there is a surplus of loanable funds. Some potential suppliers of funds will be unable to successfully supply their funds at the prevailing interest rate. Once the market interest rate decreases to i, the quantity of funds supplied is sufficiently reduced and the quantity of funds demanded is sufficiently increased such that there is no longer a surplus of funds. When a disequilibrium situation exists, market forces should cause an adjustment in interest rates until equilibrium is achieved.
If the prevailing interest rate is below i, there will be a shortage of loanable funds; borrowers will not be able to obtain all the funds that they desire at that rate. The shortage of funds will cause the interest rate to increase, resulting in two reactions. First, more savers will enter the market to supply loanable funds because the reward (interest rate) is now higher. Second, some potential borrowers will decide not to demand loanable funds at the higher interest rate. Once the interest rate rises to i, the quantity of loanable funds supplied has increased and the quantity of loanable funds demanded has decreased to the extent that a shortage no longer exists. Thus an equilibrium position is achieved once again.
Exhibit 2.7 Interest Rate Equilibrium
2-2 FACTORS THAT AFFECT INTEREST RATES
Although it is useful to identify those who supply or demand loanable funds, it is also necessary to recognize the underlying economic forces that cause a change in either the supply of or the demand for loanable funds. The following economic factors influence this supply and demand and thereby influence interest rates.
2-2a Impact of Economic Growth on Interest Rates
Changes in economic conditions cause a shift in the demand curve for loanable funds, which affects the equilibrium interest rate.
EXAMPLE
When businesses anticipate that economic conditions will improve, they revise upward the cash flows expected for various projects under consideration. Consequently, businesses identify more projects that are worth pursuing, and they are willing to borrow more funds. Their willingness to borrow more funds at any given interest rate reflects an outward shift (to the right) in the demand curve.
The supply-of-loanable-funds schedule may also change in response to economic growth, but it is difficult to know in which direction it will shift. It is possible that the increased expansion by businesses will lead to more income for construction crews and others who service the expansion. In this case, the quantity of savings (loanable funds supplied) could increase regardless of the interest rate, causing an outward shift in the supply schedule. However, there is no assurance that the volume of savings will actually increase. Even if such a shift does occur, it will likely be of smaller magnitude than the shift in the demand schedule.
Overall, the expected impact of the increased expansion by businesses is an outward shift in the demand curve but no obvious change in the supply schedule; see Exhibit 2.8 . Note that the shift in the aggregate demand curve to DA2 causes an increase in the equilibrium interest rate to i2.
Just as economic growth puts upward pressure on interest rates, an economic slowdown puts downward pressure on the equilibrium interest rate.
EXAMPLE
A slowdown in the economy will cause the demand curve to shift inward (to the left), reflecting less demand for loanable funds at any given interest rate. The supply curve may shift a little, but the direction of its shift is uncertain. One could argue that a slowdown should cause increased saving (regardless of the interest rate) as households prepare for possible layoffs. At the same time, the gradual reduction in labor income that occurs during an economic slowdown could reduce households' ability to save. Historical data support this latter expectation. Once again, any shift that does occur will likely be minor relative to the shift in the demand schedule. The equilibrium interest rate is therefore expected to decrease, as illustrated in Exhibit 2.9 .
Exhibit 2.8 Impact of Increased Expansion by Firms
2-2b Impact of Inflation on Interest Rates
Changes in inflationary expectations can affect interest rates by affecting the amount of spending by households or businesses. Decisions to spend affect the amount saved (supply of funds) and the amount borrowed (demand for funds).
EXAMPLE
Assume the U.S. inflation rate is expected to increase. Households that supply funds may reduce their savings at any interest rate level so that they can make more purchases now before prices rise. This shift in behavior is reflected by an inward shift (to the left) in the supply curve of loanable funds. In addition, households and businesses may be willing to borrow more funds at any interest rate level so that they can purchase products now before prices increase. This is reflected by an outward shift (to the right) in the demand curve for loanable funds. These shifts are illustrated in Exhibit 2.10 . The new equilibrium interest rate is higher because of these shifts in saving and borrowing behavior.
Exhibit 2.9 Impact of an Economic Slowdown
Exhibit 2.10 Impact of an Increase in Inflationary Expectations on Interest Rates
Fisher Effect More than 70 years ago, Irving Fisher proposed a theory of interest rate determination that is still widely used today. It does not contradict the loanable funds theory but simply offers an additional explanation for interest rate movements. Fisher proposed that nominal interest payments compensate savers in two ways. First, they compensate for a saver's reduced purchasing power. Second, they provide an additional premium to savers for forgoing present consumption. Savers are willing to forgo consumption only if they receive a premium on their savings above the anticipated rate of inflation, as shown in the following equation:
i = E(INF) + iR
where
· i = nominal or quoted rate of interest
· E(INF) = expected inflation rate
· iR = real interest rate
This relationship between interest rates and expected inflation is often referred to as the Fisher effect. The difference between the nominal interest rate and the expected inflation rate is the real return to a saver after adjusting for the reduced purchasing power over the time period of concern. It is referred to as the real interest rate because, unlike the nominal rate of interest, it adjusts for the expected rate of inflation. The preceding equation can be rearranged to express the real interest rate as
iR = i − E(INF)
When the inflation rate is higher than anticipated, the real interest rate is relatively low. Borrowers benefit because they were able to borrow at a lower nominal interest rate than would have been offered if inflation had been accurately forecasted. When the inflation rate is lower than anticipated, the real interest rate is relatively high and borrowers are adversely affected.
WEB
www.federalreserve.gov/monetarypolicy/fomc.htm
Information on how the Fed controls the money supply.
Throughout the text, the term “interest rate” will be used to represent the nominal, or quoted, rate of interest. Keep in mind, however, that inflation may prevent purchasing power from increasing during periods of rising interest rates.
2-2c Impact of Monetary Policy on Interest Rates
The Federal Reserve can affect the supply of loanable funds by increasing or reducing the total amount of deposits held at commercial banks or other depository institutions. The process by which the Fed adjusts the money supply is described in Chapter 4 . When the Fed increases the money supply, it increases the supply of loanable funds and this places downward pressure on interest rates.
EXAMPLE
The credit crisis intensified during the fall of 2008, and economic conditions weakened. The Fed increased the money supply in the banking system as a means of ensuring that funds were available for households or businesses that wanted to borrow funds. Consequently, financial institutions had more funds available that they could lend. The increase in the supply of loanable funds placed downward pressure on interest rates. Because the demand for loanable funds decreased during this period (as explained previously), the downward pressure on interest rates was even more pronounced. Interest rates declined substantially in the fall of 2008 in response to these two forces.
Since the economy remained weak even after the credit crisis, the Fed continued its policy of injecting funds into the banking system during the 2009–2013 period in order to keep interest rates (the cost of borrowing) low. Its policy was intended to encourage corporations and households to borrow and spend money, in order to stimulate the economy.
If the Fed reduces the money supply, it reduces the supply of loanable funds. Assuming no change in demand, this action places upward pressure on interest rates.
2-2d Impact of the Budget Deficit on Interest Rates
When the federal government enacts fiscal policies that result in more expenditures than tax revenue, the budget deficit is increased. Because of large budget deficits in recent years, the U.S. government is a major participant in the demand for loanable funds. A higher federal government deficit increases the quantity of loanable funds demanded at any prevailing interest rate, which causes an outward shift in the demand curve. Assuming that all other factors are held constant, interest rates will rise. Given a finite amount of loanable funds supplied to the market (through savings), excessive government demand for these funds tends to “crowd out” the private demand (by consumers and corporations) for funds. The federal government may be willing to pay whatever is necessary to borrow these funds, but the private sector may not. This impact is known as the crowding-out effect . Exhibit 2.11 illustrates the flow of funds between the federal government and the private sector.
There is a counterargument that the supply curve might shift outward if the government creates more jobs by spending more funds than it collects from the public (this is what causes the deficit in the first place). If this were to occur, then the deficit might not place upward pressure on interest rates. Much research has investigated this issue and has generally shown that, when holding other factors constant, higher budget deficits place upward pressure on interest rates.
2-2e Impact of Foreign Flows of Funds on Interest Rates
The interest rate for a specific currency is determined by the demand for funds denominated in that currency and the supply of funds available in that currency.
EXAMPLE
The supply and demand curves for the U.S. dollar and for Brazil's currency, the real, are compared for a given point in time in Exhibit 2.12 . Although the demand curve for loanable funds should be downward sloping for every currency and the supply schedule should be upward sloping, the actual positions of these curves vary among currencies. First, notice that the demand and supply curves are farther to the right for the dollar than for the Brazilian real. The amount of U.S. dollar-denominated loanable funds supplied and demanded is much greater than the amount of Brazilian real-denominated loanable funds because the U.S. economy is much larger than Brazil's economy.
Exhibit 2.11 Flow of Funds between the Federal Government and the Private Sector
Exhibit 2.12 Demand and Supply Curves for Loanable Funds Denominated in U.S. Dollars and Brazilian Real
Observe also that the positions of the demand and supply curves for loanable funds are much higher for the Brazilian real than for the dollar. The supply schedule for loanable funds denominated in Brazilian real shows that hardly any amount of savings would be supplied at low interest rate levels because the relatively high inflation in Brazil encourages households to spend more of their disposable income before prices increase. This discourages households from saving unless the interest rate is sufficiently high. In addition, the demand for loanable funds denominated in Brazilian real shows that borrowers are willing to borrow even at relatively high rates of interest because they want to make purchases now before prices increase. Firms are willing to pay 15 percent interest on a loan to purchase machines whose prices may increase 20 percent by the following year.
Because of the different positions of the demand and supply curves for the two currencies shown in Exhibit 2.12 , the equilibrium interest rate is much higher for the Brazilian real than for the dollar. As the demand and supply schedules change over time for a specific currency, so will the equilibrium interest rate. For example, if Brazil's government could substantially reduce local inflation, then the supply curve of loanable funds denominated in the Brazilian real would shift out (to the right) while the demand schedule of loanable funds would shift in (to the left). The result would be a lower equilibrium interest rate.
In recent years, massive flows of funds have shifted between countries, causing abrupt adjustments in the supply of funds available in each country and thereby affecting interest rates. In general, the shifts are driven by large institutional investors seeking a high return on their investments. These investors commonly attempt to invest funds in debt securities in countries where interest rates are high. However, many countries that typically have relatively high interest rates also tend to have high inflation, which can weaken their local currencies. Since the depreciation (decline in value) of a currency can more than offset a high interest rate in some cases, investors tend to avoid investing in countries with high interest rates if the threat of inflation is very high.
2-2f Summary of Forces That Affect Interest Rates
In general, economic conditions are the primary forces behind a change in the supply of savings provided by households or a change in the demand for funds by households, businesses, or the government. The saving behavior of the households that supply funds in the United States is partially influenced by U.S. fiscal policy, which determines the taxes paid by U.S. households and thus determines the level of disposable income. The Federal Reserve's monetary policy also affects the supply of funds in the United States because it determines the U.S. money supply. The supply of funds provided to the United States by foreign investors is influenced by foreign economic conditions, including foreign interest rates.
WEB
http://research.stlouisfed.org/fred2
Time series of various interest rates provided by the Federal Reserve Economic Databank.
The demand for funds in the United States is indirectly affected by U.S. monetary and fiscal policies because these policies influence economic growth and inflation, which in turn affect business demand for funds. Fiscal policy determines the budget deficit and therefore determines the federal government demand for funds.
EXAMPLE
Exhibit 2.13 plots U.S. interest rates over recent decades and illustrates how they are affected by the forces of monetary and fiscal policy. From 2000 to the beginning of 2003, the U.S. economy was very weak, which reduced the business and household demand for loanable funds and caused interest rates to decline. During the period 2005-2007, U.S. economic growth increased and interest rates rose.
However, the credit crisis that began in 2008 caused the economy to weaken substantially, and interest rates declined to extremely low levels. During the crisis, the federal government experienced a huge budget deficit as it bailed out some firms and increased its spending in various ways to stimulate the economy. Although the large government demand for funds placed upward pressure on interest rates, this pressure was offset by a weak demand for funds by firms (as businesses canceled their plans to expand). In addition, the Federal Reserve increased the money supply at this time in order to push interest rates lower in an attempt to encourage businesses and households to borrow and spend money. The weak economy and the Fed's monetary policy continued during the next four years, which allowed interest rates to remain at very low levels. The Fed's monetary policy had more influence on U.S. interest rates than any other factor during the 2008-2013 period. In some other periods, the monetary policy is not as pronounced, and other factors have more influence on interest rates.
Exhibit 2.13 Interest Rate Movements over Time
Exhibit 2.14 Framework for Forecasting Interest Rates
This summary does not cover every possible interaction among the forces that can affect interest rate movements, but it does illustrate how some key factors have an influence on interest rates over time. Because the prices of some securities are influenced by interest rate movements, those prices are affected by the factors discussed here, as explained more fully in subsequent chapters.
2-3 FORECASTING INTEREST RATES
WEB
http://research.stlouisfed.org/fred2
Quotations of current interest rates and trends of historical interest rates for various debt securities.
Exhibit 2.14 summarizes the key factors that are evaluated when forecasting interest rates. With an understanding of how each factor affects interest rates, it is possible to forecast how interest rates may change in the future. When forecasting household demand for loanable funds, it may be necessary to assess consumer credit data to determine the borrowing capacity of households. The potential supply of loanable funds provided by households may be determined in a similar manner by assessing factors that affect the earning power of households.
Business demand for loanable funds can be forecast by assessing future plans for corporate expansion and the future state of the economy. Federal government demand for loanable funds could be influenced by the economy's future state because it affects tax revenues to be received and the amount of unemployment compensation to be paid out, factors that affect the size of the government deficit. The Federal Reserve System's money supply targets may be assessed by reviewing public statements about the Fed's future objectives, although those statements are rather vague.
To forecast future interest rates, the net demand for funds (ND) should be forecast:
ND = DA − SA = (Dh + Db + Dg + Dm + Df) − (Sh + Sb + Sg + Sm + Sf)
If the forecasted level of ND is positive or negative, then a disequilibrium will exist temporarily. If ND is positive, the disequilibrium will be corrected by an upward adjustment in interest rates; if ND is negative, the disequilibrium will be corrected by a downward adjustment. The larger the forecasted magnitude of ND, the larger the adjustment in interest rates.
Some analysts focus more on changes in DA and SA than on estimating their aggregate levels. For example, assume that today the equilibrium interest rate is 7 percent. This interest rate will change only if DA and SA change to create a temporary disequilibrium. If the government demand for funds (Dg) is expected to increase substantially and if no other components are expected to change, DA will exceed SA, placing upward pressure on interest rates. Thus the forecast of future interest rates can be derived without estimating every component comprised by DA and SA.
SUMMARY
· ▪ The loanable funds framework shows how the equilibrium interest rate depends on the aggregate supply of available funds and the aggregate demand for funds. As conditions cause the aggregate supply or demand schedules to change, interest rates gravitate toward a new equilibrium.
· ▪ The relevant factors that affect interest rate movements include changes in economic growth, inflation, the budget deficit, foreign interest rates, and the money supply. These factors can have a strong impact on the aggregate supply of funds and/or the aggregate demand for funds and can thereby affect the equilibrium interest rate. In particular, economic growth has a strong influence on the demand for loanable funds, and changes in the money supply have a strong impact on the supply of loanable funds.
· ▪ Given that the equilibrium interest rate is determined by supply and demand conditions, changes in the interest rate can be forecasted by forecasting changes in the supply of and the demand for loanable funds. Thus, the factors that influence the supply of funds and the demand for funds must be forecast in order to forecast interest rates.
POINT COUNTER-POINT
Does a Large Fiscal Budget Deficit Result in Higher Interest Rates?
Point No. In some years (such as 2008), the fiscal budget deficit was large but interest rates were very low.
Counter-Point Yes. When the federal government borrows large amounts of funds, it can crowd out other potential borrowers, and the interest rates are bid up by the deficit units.
Who Is Correct? Use the Internet to learn more about this issue and then formulate your own opinion.
QUESTIONS AND APPLICATIONS
· 1. Interest Rate Movements Explain why interest rates changed as they did over the past year.
· 2. Interest Elasticity Explain what is meant by interest elasticity. Would you expect the federal government's demand for loanable funds to be more or less interest-elastic than household demand for loanable funds? Why?
· 3. Impact of Government Spending If the federal government planned to expand the space program, how might this affect interest rates?
· 4. Impact of a Recession Explain why interest rates tend to decrease during recessionary periods. Review historical interest rates to determine how they reacted to recessionary periods. Explain this reaction.
· 5. Impact of the Economy Explain how the expected interest rate in one year depends on your expectation of economic growth and inflation.
· 6. Impact of the Money Supply Should increasing money supply growth place upward or downward pressure on interest rates?
· 7. Impact of Exchange Rates on Interest Rates Assume that if the U.S. dollar strengthens it can place downward pressure on U.S. inflation. Based on this information, how might expectations of a strong dollar affect the demand for loanable funds in the United States and U.S. interest rates? Is there any reason to think that expectations of a strong dollar could also affect the supply of loanable funds? Explain.
· 8. Nominal versus Real Interest Rate What is the difference between the nominal interest rate and the real interest rate? What is the logic behind the implied positive relationship between expected inflation and nominal interest rates?
· 9. Real Interest Rate Estimate the real interest rate over the last year. If financial market participants overestimate inflation in a particular period, will real interest rates be relatively high or low? Explain.
· 10. Forecasting Interest Rates Why do forecasts of interest rates differ among experts?
Advanced Questions
· 11. Impact of Stock Market Crises During periods when investors suddenly become fearful that stocks are overvalued, they dump their stocks and the stock market experiences a major decline. During these periods, interest rates also tend to decline. Use the loanable funds framework discussed in this chapter to explain how the massive selling of stocks leads to lower interest rates.
· 12. Impact of Expected Inflation How might expectations of higher oil prices affect the demand for loanable funds, the supply of loanable funds, and interest rates in the United States? Will the interest rates of other countries be affected in the same way? Explain.
· 13. Global Interaction of Interest Rates Why might you expect interest rate movements of various industrialized countries to be more highly correlated in recent years than in earlier years?
· 14. Impact of War War tends to cause significant reactions in financial markets. Why would a war in Iraq place upward pressure on U.S. interest rates? Why might some investors expect a war like this to place downward pressure on U.S. interest rates?
· 15. Impact of September 11 Offer an argument for why the terrorist attack on the United States on September 11, 2001, could have placed downward pressure on U.S. interest rates. Offer an argument for why that attack could have placed upward pressure on U.S. interest rates.
· 16. Impact of Government Spending Jayhawk Forecasting Services analyzed several factors that could affect interest rates in the future. Most factors were expected to place downward pressure on interest rates. Jayhawk also expected that, although the annual budget deficit was to be cut by 40 percent from the previous year, it would still be very large. Thus, Jayhawk believed that the deficit's impact would more than offset the effects of other factors, so it forecast interest rates to increase by 2 percentage points. Comment on Jayhawk's logic.
· 17. Decomposing Interest Rate Movements The interest rate on a one-year loan can be decomposed into a one-year, risk-free (free from default risk) component and a risk premium that reflects the potential for default on the loan in that year. A change in economic conditions can affect the risk-free rate and the risk premium. The risk-free rate is normally affected by changing economic conditions to a greater degree than is the risk premium. Explain how a weaker economy will likely affect the risk-free component, the risk premium, and the overall cost of a one-year loan obtained by (a) the Treasury and (b) a corporation. Will the change in the cost of borrowing be more pronounced for the Treasury or for the corporation? Why?
· 18. Forecasting Interest Rates Based on Prevailing Conditions Consider the prevailing conditions for inflation (including oil prices), the economy, the budget deficit, and the Fed's monetary policy that could affect interest rates. Based on these conditions, do you think interest rates will likely increase or decrease during this semester? Offer some logic to support your answer. Which factor do you think will have the greatest impact on interest rates?
· 19. Impact of Economic Crises on Interest Rates When economic crises in countries are due to a weak economy, local interest rates tend to be very low. However, if the crisis was caused by an unusually high rate of inflation, interest rates tend to be very high. Explain why.
· 20. U.S. Interest Rates during the Credit Crisis During the credit crisis, U.S. interest rates were extremely low, which enabled businesses to borrow at a low cost. Holding other factors constant, this should result in a higher number of feasible projects, which should encourage businesses to borrow more money and expand. Yet many businesses that had access to loanable funds were unwilling to borrow during the credit crisis. What other factor changed during this period that more than offset the potentially favorable effect of the low interest rates on project feasibility, thereby discouraging businesses from expanding?
· 21. Political Influence on Interest Rates Offer an argument for why a political regime that favors a large government will cause interest rates to be higher. Offer at least one example of why a political regime that favors a large government will cause interest rates to be lower. [Hint: Recognize that the government intervention in the economy can influence other factors that affect interstates.]
· 22. Impact of Stock Market Uncertainty Consider a period in which stock prices are very high, such that investors begin to think that stocks are overvalued and their valuations are very uncertain. If investors decide to move their money into much safer investments, how do you think this would affect general interest rate levels? In your answer, use the loanable funds framework by explaining how the supply or demand for loanable funds would be affected by the investor actions, and how this force would affect interest rates.
· 23. Impact of the European Economy In 2012, some economists suggested that U.S. interest rates are dictated by the weak economic conditions in Europe. Use the loanable funds framework to explain how European economic conditions might affect U.S. interest rates.
Interpreting Financial News
Interpret the following comments made by Wall Street analysts and portfolio managers.
· a. “The flight of funds from bank deposits to U.S. stocks will pressure interest rates.”
· b. “Since Japanese interest rates have recently declined to very low levels, expect a reduction in U.S. interest rates.”
· c. “The cost of borrowing by U.S. firms is dictated by the degree to which the federal government spends more than it taxes.”
Managing in Financial Markets
Forecasting Interest Rates As the treasurer of a manufacturing company, your task is to forecast the direction of interest rates. You plan to borrow funds and may use the forecast of interest rates to determine whether you should obtain a loan with a fixed interest rate or a floating interest rate. The following information can be considered when assessing the future direction of interest rates.
· ▪ Economic growth has been high over the last two years, but you expect that it will be stagnant over the next year.
· ▪ Inflation has been 3 percent over each of the last few years, and you expect that it will be about the same over the next year.
· ▪ The federal government has announced major cuts in its spending, which should have a major impact on the budget deficit.
· ▪ The Federal Reserve is not expected to affect the existing supply of loanable funds over the next year.
· ▪ The overall level of savings by households is not expected to change.
· a. Given the preceding information, assess how the demand for and the supply of loanable funds would be affected, if at all, and predict the future direction of interest rates.
· b. You can obtain a one-year loan at a fixed rate of 8 percent or a floating-rate loan that is currently at 8 percent but would be revised every month in accordance with general interest rate movements. Which type of loan is more appropriate based on the information provided?
· c. Assume that Canadian interest rates have abruptly risen just as you have completed your forecast of future U.S. interest rates. Consequently, Canadian interest rates are now 2 percentage points above U.S. interest rates. How might this specific situation place pressure on U.S. interest rates? Considering this situation along with the other information provided, would you change your forecast of the future direction of U.S. interest rates?
PROBLEMS
· 1. Nominal Rate of Interest Suppose the real interest rate is 6 percent and the expected inflation rate is 2 percent. What would you expect the nominal rate of interest to be?
· 2. Real Interest Rate Suppose that Treasury bills are currently paying 9 percent and the expected inflation rate is 3 percent. What is the real interest rate?
FLOW OF FUNDS EXERCISE
How the Flow of Funds Affects Interest Rates
Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months. Thus, Carson's cost of obtaining funds is sensitive to interest rate movements. Given its expectations that the U.S. economy will strengthen, Carson plans to grow in the future by expanding and by making acquisitions. Carson expects that it will need substantial long-term financing to pay for this growth, and it plans to borrow additional funds either through existing loans or by issuing bonds. The company is also considering the possibility of issuing stock to raise funds in the next year.
· a. Explain why Carson should be very interested in future interest rate movements.
· b. Given Carson's expectations, do you think the company anticipates that interest rates will increase or decrease in the future? Explain.
· c. If Carson's expectations of future interest rates are correct, how would this affect its cost of borrowing on its existing loans and on its future loans?
· d. Explain why Carson's expectations about future interest rates may affect its decision about when to borrow funds and whether to obtain floating-rate or fixed-rate loans.
INTERNET/EXCEL EXERCISES
· 1. Go to http://research.stlouisfed.org/fred2 . Under “Categories,” select “Interest rates” and then select the three-month Treasury-bill series (secondary market). Describe how this rate has changed in recent months. Using the information in this chapter, explain why the interest rate changed as it did.
· 2. Using the same website, retrieve data at the beginning of the last 20 quarters for interest rates (based on the three-month Treasury-bill rate) and the producer price index for all commodities and place the data in two columns of an Excel spreadsheet. Derive the change in interest rates on a quarterly basis. Then derive the percentage change in the producer price index on a quarterly basis, which serves as a measure of inflation. Apply regression analysis in which the change in interest rates is the dependent variable and inflation is the independent variable (see Appendix B for information about applying regression analysis). Explain the relationship that you find. Does it appear that inflation and interest rate movements are positively related?
WSJ EXERCISE
Forecasting Interest Rates
Review information about the credit markets in a recent issue of the Wall Street Journal. Identify the factors that are given attention because they may affect future interest rate movements. Then create your own forecasts as to whether interest rates will increase or decrease from now until the end of the school term, based on your assessment of any factors that affect interest rates. Explain your forecast.
ONLINE ARTICLES WITH REAL-WORLD EXAMPLES
Find a recent practical article available online that describes a real-world example regarding a specific financial institution or financial market that reinforces one or more concepts covered in this chapter.
If your class has an online component, your professor may ask you to post your summary of the article there and provide a link to the article so that other students can access it. If your class is live, your professor may ask you to summarize your application of the article in class. Your professor may assign specific students to complete this assignment or may allow any students to do the assignment on a volunteer basis.
For recent online articles and real-world examples related to this chapter, consider using the following search terms (be sure to include the prevailing year as a search term to ensure that the online articles are recent):
· 1. budget deficit AND interest rate
· 2. flow of funds AND interest rate
· 3. Federal Reserve AND interest rate
· 4. economic growth AND interest rate
· 5. inflation AND interest rate
· 6. monetary policy AND interest rate
· 7. supply of savings AND interest rate
· 8. business expansion AND interest rate
· 9. demand for credit AND interest rate
· 10. interest rate AND forecast
