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Topic 1

An Understanding of
Money & Interest Rates
 TEXTBOOK
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 What is interest rate?
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 The act of saving and lending, borrowing and

investing, significantly influenced 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.
 What is interest rate?
1-4

 Some authorities refer to the rate of interest as the

price of credit.
 Interest rates send price signals to borrowers, lender,
savers, and investors.
 Whether higher interest rates increase or decrease
the savings and investment, it depends on the relative
strength of its effect on supply and demand factors.
 Functions of the Interest Rate in the Economy
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 Facilitates the flow of current savings into investments

that promote economic growth.
Ex: Banks can attract household savings by offering
interest on deposits.
 Allocates the available supply of credit to those
investment project with highest returns.
Ex: If interest rate is too high, therefore cost of
borrowing will be high and could cause profitable
project making loses.
 Functions of the Interest Rate in the Economy
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 Adjustment in interest rates can bring the supply of

money into balance with demand.
Ex: If money supply exceeds demand, a decrease in
interest rate would occur and vice versa.
 Act as important tool of government policy through
their influence on the volume of savings and
investments.
Ex: If economy is growing slowly and unemployment is
rising, government can use its policy tools to lower
interest rate to stimulate borrowing and investment.
 Theory of Interest Rates
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 The Classical Theory

 The Liquidity Preference or Cash Balances Theory
 The Loanable Funds Theory
 The Rational Expectations Theory
 The Classical Theory
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 The classical theory argues that the rate of interest is

determined by two forces:
 the supply of savings

 the demand for investment capital

 Supply of savings is assumed to be positively related

to the market interest rates.
 Demand for investment capital is negatively related to
the market interest rates.
 Equilibrium achieved when supply = demand
 The Classical Theory - Supply of Savings
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i) Household Savings
 Current household savings equal to 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.

 The Classical Theory - Supply of Savings
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The Substitution Effect

Relating Savings and Interest Rates
Interest
Rate
r2 
r1 

Current
S1 S2 Saving
 The Classical Theory - Supply of Savings
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ii) 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.
iii) Government
 Income flows in the economy and the pacing of
government spending programs are the dominant
factors affecting government savings (budget
surplus).
 The Classical Theory - Demand for
Investment Funds
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 Gross business investment equals the sum of

replacement investment and net investment.
*Replacement investment = expenditures to replace equipment and facilities
that wearing out or technologically obsolete.
*Net investment = expenditures to acquire new equipment and facilities to
increase output.
 Investment decision-making method involves the
calculation of a project’s 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.
 The Classical Theory - Demand for
Investment Funds
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 The internal rate of return (r) equates the total cost

of an investment project with the future net cash flows
(NCF) expected from that project discounted back to
their present values.
 Cost of project = NCF1 NCF2 NCFn
  ... 
1  r  1  r 
1 2
1  r n
 The Classical Theory - Demand for
Investment Funds
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The Cost of Capital and the Business Investment Decision

Expected
Internal A – acceptable
Rates of 15%
Return on B – acceptable
Alternative Cost of
Investment 12% C – indifferent Capital
Projects Funds
10% D = 10%
unprofitable 8% E
unprofitable 7%

Dollar Cost of Investment Projects

 The Classical Theory - Demand for
Investment Funds
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The Investment Demand Schedule

In the Classical Theory of Interest Rates
Interest
Rate
r2 
r1 

Investment
I2 I1 Spending
 The Classical Theory - Demand for
Investment Funds
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The Equilibrium Rate of Interest In the Classical Theory

Interest
Rate Investment Savings

rE 

Savings &
QE Investment
 Limitations of The Classical Theory
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 The theory ignores factors other than saving and

investment that affect interest rates.
 The theory assumes that interest rates are the
principal determinant of the quantity of savings
available.
 The theory contends that the demand for borrowed
funds comes principally from the business sector.
 The Liquidity Preference (Cash Balances) Theory
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 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 refer to
a payment to supplier of funds for the use of scarce
resource (money or cash balances) by the demander.
 To classical theorist, it was irrational to hold cash as
it provides little or no return.
 The Liquidity Preference (Cash Balances) Theory
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 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 – uncertainty about future
prices of bonds
 The Total Demand for Money or Cash Balances &
the Equilibrium Rate of Interest
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 The Liquidity Preference (Cash Balances) Theory
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 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. (not by interest rate)
 The Liquidity Preference (Cash Balances) Theory
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The Equilibrium Interest Rate

In the Liquidity Preference Theory
Interest
Rate Money
Supply

Equilibrium
interest rate  Total
Demand

Quantity of
Money / Cash
QE Balances
 Limitations of The Liquidity Preference
(Cash Balances) Theory
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 It is a short-term approach that fails to capture the

fact that over a longer term period, interest rates are
affected by changes in level of income and
inflationary expectations.
 It is impossible to have a stable equilibrium interest
rate without reaching equilibrium level of income,
savings and investments in the economy.
 It only considers supply and demand for money
whereas business, consumer and government demands
for financing have impact on cost of financing.
 The Loanable Funds Theory
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 The theory argues that the risk-free interest rate is

determined by the interplay of two forces:
 the demand for 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
 The Loanable Funds Theory
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 Loanable funds?
The sum total of all the money people and entities
in an economy have decided to save and lend out
to borrowers as an investment rather than use for
personal consumption
 The Loanable Funds Theory
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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.
 The Loanable Funds Theory
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Total Demand for Loanable Funds (Credit)

Interest
Rate
Total Demand = Dconsumer +
Dbusiness +
Dgovernment +
Dforeign

Amount of
Loanable Funds
 The Loanable Funds Theory
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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.
 The Loanable Funds Theory
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 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.
 The Loanable Funds Theory
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Total Supply of Loanable Funds (Credit)

Interest
Rate Total Supply
= domestic savings +
newly created money +
foreign lending –
hoarding demand

Amount of
Loanable Funds
 The Loanable Funds Theory
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The Equilibrium Interest Rate

Interest
Rate Supply

rE 

Demand
Amount of
QE Loanable Funds
 The Loanable Funds Theory
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 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
 Interest rates will be stable only when the economy, money
market, loanable funds market, and foreign currency
markets are simultaneously in equilibrium.
 The Loanable Funds Theory
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 Effects of increased supply of loanable funds with

demand unchanged

Interest
Rate D0 S1
S2

I1 
I2 

Amount of
C1 C2 Loanable Funds
 The Loanable Funds Theory
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 Effects of increased demand of loanable funds with

supply unchanged

Interest
Rate D2 S0
D1

I2 
I1 

Amount of
C1 C2 Loanable Funds
 The Rational Expectations Theory
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 The rational expectations theory builds on a growing

body of research evidence that the money and capital
markets are highly efficient in digesting new
information that affects interest rates and security
prices.
 For example, when new information appears about
investment, saving or the money supply, investors
begin immediately to translate the new information
into decision to lend or to borrow funds.
 The Rational Expectations Theory
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 The public forms rational and unbiased expectations

about the future demand and supply of credit, and
hence interest rates.

Interest Expected Supply

Rate
rE 

Expected Demand
Amount of
QE Loanable Funds
 The Rational Expectations Theory
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 If the money and capital markets are highly efficient,

then interest rates will always be very near their
equilibrium levels.
 Interest rates will change only if entirely new and
unexpected information appears, and the direction of
change depends on the public’s current set of
expectations.
 Present Value
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 The concept of present value (or present discounted

value) is based on the common sense notion that
“a dollar of cash flow paid to you next year is less
valuable to you than a dollar paid to you today”.
 This notion is true because you could invest the dollar
in a savings account that earns interest and have more
than a dollar in one year.
 The term present value (PV) can be extended to the
PV of a single cash flow or the sum of a sequence or
group of cash flows.
 Present Value Concept
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 There are four basic types of credit instruments which

incorporate present value concepts:
1. Simple Loan
2. Fixed Payment Loan
3. Coupon Bond
4. Discount Bond
 Present Value Concept : Simple Loan
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Simple Loans require payment of one amount which equals

the loan principal plus the interest.
 Loan Principal: the amount of funds the lender provides to the
borrower.
 Maturity Date: the date the loan must be repaid; the Loan Term is
from initiation to maturity date.
 Interest Payment: the cash amount that the borrower must pay the
lender for the use of the loan principal.
 Simple Interest Rate: the interest payment divided by the loan
principal; the percentage of principal that must be paid as
interest to the lender express on an annual basis.
 Present Value Concept : Simple Loan
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Simple loan of $100

Year: 0 1 2 3 n
n
$100 $110 $121 $133 100(1+i)

$1
PV of future $1 =
1+ i n
 Present Value Concept : Simple Loan
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 The previous example reinforces the concept that

$100 today is preferable to $100 a year from now
since today’s $100 could be lent out (or deposited) at
10% interest to be worth $110 one year from now, or
$121 in two years or $133 in three years.
 Present Value Concept : Simple Loan
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 Yield to maturity = interest rate that equates today's

value with present value of all future payments

$100  $110 1  i  
$110  $100 $10
i   .10  10%
$100 $100
**i = yield to maturity (YTM)
 Present Value Concept : Fixed Payment Loans
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Fixed-Payment Loans are loans where the principal

and interest are repaid in several payments, often
monthly, in equal dollar amounts over the loan term.
Example: installment loans such as automobile loans
and home mortgages.
 Present Value Concept : Fixed Payment Loans
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Yield to Maturity (YTM)

Fixed Payment Loan (i = 12%)

$126 $126 $126 $126

$1000   2  3  ... 
1 i  1  i 1 i  1 i 25

FP FP FP FP
LV   2  3  ... 
1  i  1  i  1 i  1 i n
 Present Value Concept : Coupon Bonds
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Yield to Maturity (YTM)

Coupon Payment (i = 12%)
$100 $100 $100 $100 $1000
P  2  3  ...  10 
1 i  1  i 1 i  1 i  1  i 10

C C C C F
P  2  3  ...  n 
1 i  1  i 1 i  1 i  1  i n

C C
P i 
i P
 Present Value Concept : Discount Bonds
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One-Year Discount Bond (P = $900, F = $1000)

$900 
$1000
 i F  P
1  i P
$1000  $900
i  .111  11.1%
$900
 Relationship Between Price and Yield to Maturity
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Note:
1. When bond is at par, yield equals coupon rate
2. Price and yield are negatively related
3. Yield greater than coupon rate when bond price is
below par value
 Distinction Between Real & Nominal Interest Rates
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 Real interest rate

1. Interest rate that is adjusted for expected
changes in the price level

ir  i   e

2. Real interest rate more accurately reflects true

cost of borrowing
3. When real rate is low, greater incentives to
borrow and less to lend
 Distinction Between Real & Nominal Interest Rates
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 If i = 5% and πe = 0% then

ir  5% 0% 5%

 If i = 10% and πe = 20% then

ir  10% 20% 10%
 Distinction Between Interest Rates and Returns
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 Reinvestment Risk
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1. Occurs if hold series of short bonds over

long holding period
2. i at which reinvest uncertain
3. Gain from i , lose when i 
 Calculating Duration
i =10%, 10-Year 10% Coupon Bond
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 Calculating Duration
i = 20%, 10-Year 10% Coupon Bond
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 Formula for Duration of Bond
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n n
CPt CPt
DUR   t 
t 1 1  i t 1 1  i
t t

 Key facts about duration

1. All else equal, when the maturity of a bond
lengthens, the duration rises as well
2. All else equal, when interest rates rise, the duration
of a coupon bond fall
3. All else equal, the higher the coupon rate, the
shorter bond’s duration
 Formula for Duration of Bond
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i
%P   DUR 
1 i
 From Table 3, if i  10% to 11%:
0.01
%P  6.76 
1  0.10

%P  0.0615  6.15%

 Formula for Duration of Bond
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 From Table 4, if i  10% to 11%:

0.01
%P  5.72 
1  0.10

%P  0.0520  5.20%

 Formula for Duration of Bond
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 The greater is the duration of a security, the greater

is the percentage change in the market value of the
security for a given change in interest rates

 Therefore, the greater is the duration of a security,

the greater is its interest-rate risk
 Question & Application
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A government bond is scheduled to mature in 5

years. Its coupon rate is 10 percent, with
interest paid to holders of record at the
conclusion of each year. This $1,000 par value
carries a current yield to maturity of 10
percent. What is its duration?
 Question & Application
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Duration = 4169.87/1000.00 = 4.17 years.

 Question & Application
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What is inflation? Why is it important?

 Inflation refers to a rise in the average level of prices
for all goods and services in an economy.
 It is important as inflation creates distortions in the
allocation of scarce resources and definitely hurts
certain groups.
 For example, it tends to discourage savings - In turn,
the decline in the savings rate tends to discourage
capital investment and hence declining in the
economy's growth.