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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
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
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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
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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
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
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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
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Loanable Funds Theory (cont’d)
D
h
Household Demand
D
b
Business Demand
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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 .
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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
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