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