Theories of interest rates

5-2

Learning Objectives
To understand the important roles and
functions that interest rates perform
within the economy and the financial
system.
To explore the most important ideas about
the determinants of interest rates and asset
prices.
To identify the key forces that economists
believe set market interest rates and asset
prices into motion.

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Introduction
The acts of saving and lending, and
borrowing and investing, are significantly
influenced by and tied together by the
interest rate.
The interest rate is the price a borrower
must pay to secure scarce loanable funds
from a lender for an agreed-upon time
period.

Functions of the Interest Rate in the

Economy
The interest rate helps guarantee that
current savings will flow into investment
to promote economic growth.
It rations the available supply of credit,
generally providing loanable funds to those
investment projects with the highest return.
It brings the supply of money into balance
with the publics demand for money.

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Functions of the Interest Rate in the

Economy
The interest rate serves as an important
tool for government policy through its
influence on the volume of savings and
investment.

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The Classical Theory of Interest Rates

The classical theory argues that the rate
of interest is determined by two forces:
the supply of savings, derived mainly
from households, and
the demand for investment capital,
coming mainly from the business
sector.

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The Classical Theory of Interest Rates

Household Savings
Current household savings equal the
difference between current income and
current consumption expenditures.
Individuals prefer current over future
consumption, and the payment of interest
is a reward for waiting.
Higher interest rates encourage the
substitution of current saving for current
consumption.

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The Classical Theory of Interest Rates

The Substitution Effect
Relating Savings and Interest Rates
Interest
Rate
r2
r1

S1

S2

Current
Saving

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The Classical Theory of Interest Rates

Business and Government Savings
Most businesses hold savings balances in
the form of retained earnings, the amount
of which is determined principally by
business profits, and to a lesser extent, by
interest rates.
Income flows in the economy and the
pacing of government spending programs
are the dominant factors affecting
government savings (budget surplus).

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The Classical Theory of Interest Rates

The Demand for Investment Funds
Gross business investment equals the sum of
replacement investment and net investment.
The investment decision-making process
typically involves the calculation of a projects
expected internal rate of return, and the
comparison of that expected return with the
anticipated returns of alternative projects, as
well as with market interest rates.

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The Classical Theory of Interest Rates

The Investment Demand Schedule
In the Classical Theory of Interest Rates
Interest
Rate
r2

r1

I2

I1

Investment
Spending

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The Classical Theory of Interest Rates

The Equilibrium Rate of Interest
In the Classical Theory of Interest Rates
Interest
Rate Investment Savings
rE

QE

Savings &
Investment

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The Classical Theory of Interest Rates

Limitations
Factors other than savings and investment
that affect interest rates are ignored. For
example, many financial institutions can
create money today by making loans to
the public.
Today, economists recognize that income
is more important than interest rates in
determining the volume of savings.

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The Classical Theory of Interest Rates

Limitations
In addition to the business sector, both
consumers and governments are also
important borrowers today.

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The Liquidity Preference (Cash Balances)

Theory of Interest Rates
The liquidity preference (or cash balances)
theory of interest rates is a short-term
theory that was developed for explaining
near-term changes in interest rates, and
hence, is more relevant for policymakers.
According to the theory, the rate of interest
is the payment to money (cash balances)
holders for the use of their scarce resource
(liquidity), by those who demand liquidity
(i.e. money or cash balances).

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The Liquidity Preference (Cash Balances)

Theory of Interest Rates
The demand for liquidity stems from:
the transactions motive - the purchase of goods and
services
the precautionary motive - to cope with future
emergencies and extraordinary expenses
the speculative motive - a rise in interest rates results
in higher demand for bonds, hence lower demand for
liquidity.
and depend on the level of national income,

business sales, and prices (but not interest rates). So,

demand due to and is fixed in the short term.

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The Liquidity Preference (Cash Balances)

Theory of Interest Rates
The Total Demand for Money or Cash Balances
in the Economy
Interest
Rate

Total Demand
= ++

: transactions
demand
: precautionary
demand
: speculative
demand
Quantity of
Money / Cash
Balances

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Interest
Rate

The Money Market

Money Supply

If the RBI buys

government
bonds, money
supply
increases.

QFixed

Quantity of Money

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Interest
Rate

The Money Market

Money Supply

If the RBI sells

government
bonds, money
supply
decreases.

QFixed

Quantity of Money

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The Liquidity Preference (Cash Balances)

Theory of Interest Rates
The Equilibrium Interest Rate
In the Liquidity Preference Theory
Interest
Rate

rE

Money
Supply

QE

Total
Demand
Quantity of
Money / Cash
Balances

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The Liquidity Preference (Cash Balances)

Theory of Interest Rates
In modern economies, the money supply
is controlled, or at least closely regulated,
by the government.
The supply of money (cash balances) is
often assumed to be inelastic with respect
to interest rates, since government
decisions concerning the size of the
money supply should presumably be
guided by public welfare.

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The Liquidity Preference (Cash Balances)

Theory of Interest Rates
Limitations
The liquidity preference theory is a short-term
approach. In the longer term, the assumption
that income remains stable does not hold.
Only the supply and demand for money is
considered. A more comprehensive view that
considers the supply and demand for credit by
all actors in the financial system - businesses,
households, and governments - is needed.

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The Loanable Funds Theory of Interest

The popular loanable funds theory argues
that the risk-free interest rate is
determined by the interplay of two forces:
the

demand for credit (loanable funds) by

domestic businesses, consumers, and
governments, as well as foreign borrowers
the supply of loanable funds from domestic
savings, dishoarding of money balances,
money creation by the banking system, as
well as foreign lending

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The Loanable Funds Theory of Interest

The Demand for Loanable Funds
Consumer (household) demand is relatively
inelastic with respect to the rate of interest.
Domestic business demand increases as the
rate of interest falls.
Government demand does not depend
significantly upon the level of interest rates.
Foreign demand is sensitive to the spread
between domestic and foreign interest rates.

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The Loanable Funds Theory of Interest

Total Demand for Loanable Funds (Credit)
Interest
Rate

Total Demand

Amount of
Loanable Funds

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The Loanable Funds Theory of Interest

The Supply of Loanable Funds
Domestic Savings. The net effect of income,
substitution, and wealth effects is a
relatively interest-inelastic supply of savings
curve.
Dishoarding of Money Balances. When
individuals and businesses dispose of their
excess cash holdings, the supply of loanable
funds available to others is increased

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The Loanable Funds Theory of Interest

The Supply of Loanable Funds
Creation of Credit by the Domestic
Banking System. Commercial banks and
nonbank thrift institutions offering
payments accounts can create credit by
lending and investing their excess
reserves.
Foreign lending is sensitive to the spread
between domestic and foreign interest
rates.

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The Loanable Funds Theory of Interest

Total Supply of Loanable Funds (Credit)
Interest
Rate

Total Supply

= domestic savings +
newly created money +
foreign lending
hoarding demand

Amount of
Loanable Funds

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The Loanable Funds Theory of Interest

The Equilibrium Interest Rate
Interest
Rate
rE

Supply

Demand
QE

Amount of
Loanable Funds

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The Loanable Funds Theory of Interest

At equilibrium:
Planned savings = planned investment across the
whole economic system
Money supply = money demand
Supply of loanable funds = demand for loanable
funds
Net foreign demand for loanable funds = net
exports

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The Loanable Funds Theory of Interest

Interest

rates will be stable only when the

economy, money market, loanable funds
market, and foreign currency markets are
simultaneously in equilibrium.