Financial Institution

Zaheer Swati 1

Unit 7

INTEREST RATE DETERMINATION
Interest rate depends on two things:
1- The rate of return on investment: the higher the return on investment, the more likely producers are to undertake
a particular investment project
2- The time preference between current and future consumption: most people prefer to consume goods today
rather than tomorrow. This is known as the positive time preference for consumption
Investment is negatively related to interest rate. That is, other things remaining equal, the higher the interest rate the
lower the investment (because cost of borrowing increase if interest rate increase)
Saving is positively related to the interest rate. That is, other things remaining equal, the higher the interest rate, the
higher the savings are.
This relationship gives:
Downward sloping demand curve for desired investment, and
Upward sloping supply curve of desired saving
The interaction of these two determines the rate if interest as shown in the figure below:


The two curves show that consumers will save more if producers offer higher interest rates on savings, and producers
will borrow more if consumers will accept lower return on their savings
The market equilibriumrate of interest (r*) is achieved when desired saving (s*) by savers equals desired investment
(I*) by producers across all economic units
This equilibriumrate of interest is called the real rate of interest. The real rate of interest is the fundamental long-run
interest rate in the economy. It is called the "real" rate of interest because it is determined by the real output of the
economy
Three theories on interest rate determination

S*=I*
r*
Interest rate
Desired Savings (DS)
Desired Investments (DI)
Saving & investment
Financial Institution


Zaheer Swati 2

Unit 7

7.1 Loanable Funds Theory
As noted above, the real interest rate is a long-run interest rate, so what determine interest rate in the short-run. The
loanable funds theory is a framework used to determine interest rate in the short-run
According to this the interest rate is determine by the demand for and supply of direct and indirect financial claims on
the primary and secondary markets during a given time period
The need to sell financial claims represents the demand for loanable funds (deficit spending unit)
Individuals and Households
Businesses
Governments
Foreign Demand
Buying of financial claims to earn interest represent the supply of loanable fund (surplus spending unit)
Individuals and Households only net saver of funds
Businesses
Governments
Foreigners
In general:
Increases in interest rate will stimulate (motivate) more saving and increase supply of loanable funds
So, the loanable fund supply curve slopes upward. That is, there is a positive relationship between interest rate and
supply of loanable funds
Demand for loanable funds decreases as the interest rate increases (due to increase in cost of borrowing). That is, there
is a negative relationship between interest rate and demand for loanable funds. So that demand for loanable funds curve
slopes downward
The intersection of supply and demand for loanable funds determines the equilibriuminterest rate and the equilibrium
quantity of loanable funds loaned out and demanded
Changes in interest rate, brings changes in quantity demanded and supplied of loanable funds, and is represented by a
movement along SL and DL curve



Q
0
SL
DL
r
1
r
0
r
2
Interest rate
Loanable funds
Financial Institution


Zaheer Swati 3

Unit 7

Therefore:
If interest rate is at r
1
(below equilibrium), shortage of loanable funds exist, which force the interest up. And
If interest rate is at r
2
(above equilibrium), surplus of loanable funds exist, which force the interest rate down
Changes in factors other than interest rate, changes the supply and demand for loanable funds. That is, SL and/or DL
curves shift upwards or downwards, and as a result a new equilibriumoccurs.
What are the factors other than the interest rate?

7.1.1 Factors Affecting Supply of Loanable Funds
a. Changes in the quantity of money:
If quantity of money increases ( M is +), supply of loanable funds increases (people have more money to save), the SL
curve shifts to the right (or downwards), resulting in a new equilibriumwith lower interest rate and higher equilibrium
quantity.
b. Change in the income tax:
A decrease in income tax increase saving. Thus, the supply of loanable funds increases, shifting the SL curve to the right,
decreasing r
0
and increasing Q
0
.
c. Changes in government budget from deficit to surplus position:
Reduced government expenditure increases government savings, thus shifts the SL curve to the right.
d. Expected inflation:
If lower rates of inflation are expected in the future, saving increase (current consumption decreases waiting for the
expected reduction in prices), and supply of loanable fund will increases, which shift the SL curve to the right.
e. Change in saving rate or public desire to hold money balances:
An increase in saving rate (the percentage of income saved) will increase the supply of loanable funds, shifting the SL
curve shift to the right.
f. Changes in business saving:
An increase in business saving of course increases supply of loanable funds and SL curve shift to the right.

7.1.2 Factors Affecting Demand for Loanable Funds
a. Changes in future expected profits or business activities:
If business expected higher profit in the future demand for investment or investment demand increase, and so does
demand loanable funds, DL curve shifts to the right (or upwards), resulting in a new equilibrium with higher interest rate
and higher equilibriumquantity.
b. Changes in government budget from surplus to deficit position:
Increase in government expenditure, increases government borrowing to cover its deficit, therefore the demand for
loanable funds increases, and the DL curve shifts to the right.
c. changes in tax:
A decrease in tax, increase government deficit (since government revenue decreases), and thus increases the demand for
loanable funds, and DL curve will shift to the right.
In summary:
If SL only increases, Q
0
will increase and r
0
decreases
If DL only increases, Q
0
will increase and r
0
will increase
If both SL and DL increases, Q
0
will increase r
0
might increase, decrease, or remain unchanged
Financial Institution


Zaheer Swati 4

Unit 7

7.1.3 Sources of Demand and Supply of Loanable Funds

Source of supply loanable funds:
- Consumer savings
- Business savings
- Government savings
- Central bank, changing quantity of money

Source of Demand Loanable Funds:
- Business investment
- Consumer credit purchase
- Government budget deficit

7.1.4 Criticism
The theory is criticized on the following grounds
1. Unrealistic assumption: The theory assumes the level of national income to be constant. Actually the level of
income changes with the changes in the levels of investment in the country.
2. Unrealistic integration of monetary and real factors: The theory has integrated the monetary and real factors
which affect the demand for and supply of loanable funds. Actually both these factors are to be studied separately and not
to be combined.
3. Assumption of full employment: The theory assumes full employment in the economy whereas less than full
employment is the general rule.
4. Interest-elastic factors. The theory assumes that saving, hoarding investment, etc. are related to the rate of interest.
Actually investment is not influenced by rate of interest alone. There are many other factors also which affect investment
in the country

7.2 Fishers Theory
Market interest rates = real interest rate +inflation
Inflation is included through the fisher effect theory, which states that the nominal interest rate (contract rate)
includes real interest rate and expected annual inflation rate
The Fisher effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate.
Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation
The contract rate is determined fromthe Fisher equation, which states that:

(1 +i) = (1+r)(1+P
e
) ---------------(1)

Where
i =the nominal rate of interest (the contract, observed, or market rate)
r =real rate of interest in the absence of price level changes
P
e
=expected annual change in commodity prices (expected inflation)


Financial Institution


Zaheer Swati 5

Unit 7

Solving the Fisher equation for i, we get the following equation:

i = r + P
e
+ (rP
e
) --------------- (2)

This equation shows the relationship between nominal (contract) rates and rates of expected inflation. The inflation
component of the equation (P
e
+ (rP
e
) is commonly referred to as to fisher effect.
The final term of the Fisher equation (rP
e
) is approximately equal to zero. So in many situations it is dropped from
the equation without creating a critical error. The equation without the final termis referred to as the approximate
Fisher equation and is stated as follows:

i = r + P
e
------------------------- (3)


Note that the equation can be used to calculate any of the unknowns if we know the other two:

Time period

Real rate
Expected price
change
Approximate
Nominal rate
Exact Nominal rate
0 5 0 5 5.00
1 5 7 12 12.35
2 5 7 12 12.35
3 5 9 14 14.45
4 5 3 8 8.15
5 5 -2 3 2.90
6 5 -7 0 0

However the nominal rate cannot decline below zero regardless of the rate of price decline. Lender would always
prefer to retain their money and purchase goods and services rather than to pay someone else (negative interest) to
do the same.
The nominal rate of interest is directly influenced by changes in the expected rate of inflation. That is the higher the
expected rate of inflation, the higher the nominal rate of interest

7.2.1 The Realized Real Rate
Actual inflation could be different fromexpected inflation rate
This may lead to the realized rate of return on a loan could be different from nominal interest rate agreed at the time
of the loan contract
Realized real rate is calculated using this formula:

r
r
=i - P
a

Where:
r
r
=is the realized real rate of return.
P
a
=is the actual rate of inflation.
i =is nominal interest rate.
Financial Institution


Zaheer Swati 6

Unit 7

Example 7.1:
If real rate of interest (r) =4%
Expected annual inflation rate (P
e
) =8%
So, nominal rate





If actual inflation rate (P
a
) was 5%
Then the realized rate of return is:






If actual inflation rate was 2%




If actual inflation rate (pe) was 15% then,





So, realized rate of return can be negative

7.2.2 Inflation and Loanable Funds Model
o The loanable funds theory can be used to illustrate inflations effect on financial markets
o The higher the expected inflation rate, the higher is the demand for loanable funds (present consumption increase),
so the DL will shift upward (to the right) by the amount pe. The shift from DL
0
to DL
1
implies that borrowers are
willing to pay the inflation premium of pe
o Similarly, the higher the expected inflation rate, the lower is supply for loanable funds (saving decrease), so the SL
will shift upward (to the left) by the amount pe. The shift from SL
0
to SL
1
will be such that lenders are given a
higher nominal yield to compensate for their loss of purchasing power
o The net effect is that the market rate of interest will rise from r to i, where the different between i and r is the
expected inflation rate (pe)
o Even though the real rate of interest (r) remains unchanged, the nominal rate of interest (i) has adjusted fully for the
anticipated rate of inflation (pe), and the quantity of loanable funds in the market has remained the same at Q
0
.

i =r +P
a

4% +8% =12%

r
r
=i- P
a

r =12% - 5% =7%
r
r
=i- P
a

r =12% - 2% =10%

r
r
=i- P
a

r =12% - 15% =-3%

Financial Institution


Zaheer Swati 7

Unit 7


7.2.3 Interest Rate Movements and Inflation
Interest rate vary directly with inflation rate, and directly with the level of economic activities, (recall that i= r + P
e

, so any change in r or P
e
will change r directly)
Generally. short-terminterest rates are more responsive to changes in expected inflation than long-terminterest rate
Thus, a monthly change in the rate of inflation would have a large affect on the expectation across a three-month
contract while it would have a small effect across a ten-years contract


7.3 Determinants of Market Interest Rates




r
d
=Required rate of return on a debt security. It is also called quoted or nominal interest rate

i
rf
= Real risk-free rate is the rate of interest on a security that is free of all risk: it is proxy by the T-bill rate or the T-
bond rate

IP =Inflation premium is the average expected inflation over the life of security. A premium equal to expected inflation
that investors add to the real risk free rate of return (higher inflation=higher IP).

DRP =Default risk premiumis the risk that issuer will not pay interest or principal at stated times. Difference between
the interest rate of a U.S. Treasury bond and a corporate bond of equal maturity and marketability (reflects the likelihood
of default; higher likelihood =higher DRP)

LP =Liquidity (marketability) premiumcharged by lenders because some securities cannot be converted to cash in short
run at a reasonable notice. Liquidity risk premiums are increases in required or promised yields designed to offset the risk
of not being able to sell the asset in timely fashion at fair value (the longer it takes to get it to cash, the higher the LP)
IR
P
e
r
SL
1
DL
0
DL
1
SL
0
i
LF
r
d
=r
rf
+IP +DRP +LP +MRP

Financial Institution


Zaheer Swati 8

Unit 7

MRP = Maturity risk premiummeans that longer term security are exposed to significant risk of price declines due to
increases in inflation and interest rates. The longer the security must be held, the higher the MRP

Example 7.2: Fill in the following table by placing a check mark indicating which premiums are included in which of the
following securities.
Interest Premium Maturity Risk
Premium
Default Risk
Premium
Liquidity Premium
ST Treasury X
LT Treasury X X
ST Corporate X x
LT Corporate X X x x


Example 7.3: 30 day T-bills are currently yielding 5.5%. The following are current expected interest rate premiums
Inflation Premium=3.45%
Liquidity Premium=0.76%
Maturity Risk Premium=1.65%
Default Risk Premium=2.45%

What is the real risk free rate of return?
Solution:
Yield=r =5.5%
T Bill Rate=r* +IP
5.5% =r* +3.45
-3.45 - 3.45
2.05= r*


Example 7.4: A companys 5 year bonds are yielding 7.85% each year. Treasury bonds with the same maturity are
yielding 4.82% per year, and the real risk free rate (r
rf
) is 2.3%. The average inflation premiumis 2.5% and the maturity
risk premium is estimated to be 0.1 X (t-1) % where t=years to maturity. If the liquidity premiumis .8%, what is the
default risk premiumon the corporate bonds?
Solution:
r= r* + IP + DRP + LP + MRP
7.85=2.3 +2.5 +DRP +.8 +(.1) (5-1)
7.85=2.3 +2.5 +DRP +.8 +.4
7.85=6 +DRP
-6 -6
1.85%=DRP


Financial Institution


Zaheer Swati 9

Unit 7

Example 7.5: The real risk free rate is 4%. Inflation is expected to be 2.5% in year one, 3.4% in year two and 5% each
year following. The maturity risk premiumis 0.05 (t-1)%. (t=number of years to maturity) What is the yield on a 6 year
treasury note?
Solution:
r= r* + IP + DRP + LP + MRP

r*=4%
IP=(2.5 +3.4 +5(4))/ 6 =4.31667 or about 4.32%
MRP=.05 (6-1) =.25%
DRP=0
LP=0
r=4 +4.32 +.25
=8.57

Example 7.6: Suppose most investors expect the inflation rate to be 5 percent next year, 6 percent the following year,
and 8 percent thereafter. The real risk-free rate is 3 percent. The maturity risk premiumis zero for securities that mature
in 1 year or less, 0.1 percent for 2-year securities, and then the MRP increases by 0.1 percent per year thereafter for 20
years, after which it is stable. What is the interest rate on 1-year, 10-year, and 20-year treasury securities? Draw a yield
curve with these data. What factors can explain why this constructed yield curve is upward sloping?
Solution:
Step 1: Find the average expected inflation rate over years 1 to 20:

Yr 1: IP =5.0%.

Yr 10: IP =(5 +6 +8 +8 +8 +... +8)/10 =7.5%.

Yr 20: IP =(5 +6 +8 +8 +... +8)/20 =7.75%.

Step 2: Find the maturity premiumin each year:

Yr 1: MRP =0.0%.

Yr 10: MRP =0.1 9 =0.9%.

Yr 20: MRP =0.1 19 =1.9%.

Step 3: Sum the IPS and MRPS, and add r* =3%:

Yr 1: r
RF
=3% +5.0% +0.0% =8.0%.

Yr 10: r
RF
=3% +7.5% +0.9% =11.4%.

Yr 20: r
RF
=3% +7.75% +1.9% =12.65%.

Financial Institution


Zaheer Swati 10

Unit 7

The shape of the yield curve depends primarily on two factors:
(1) expectations about future inflation and (2) the relative riskiness of securities with different maturities.
The constructed yield curve is upward sloping. This is due to increasing expected inflation and an increasing maturity
risk premium.




13
12
11
10
9
8
Years to maturity
0 1 5 10 15 20
Interest
rate (%)