Determination of Interest
Rate
The rate of interest
Interest rate is a rate of return paid by a borrower of funds to a lender of them, or a price paid by a
borrower for a service, the right to make use of funds for a specified period. Thus it is one form of yield on financial instruments.
Interest rate theories:
loanable funds theory
The loanable funds theory was formulated by the Swedish economist Knut Wicksell in the 1900s.
According to him, the level of interest rates is determined by the supply and demand of loanable funds available in an economy’s credit market.
The term “supply of loanable fund” is commonly used to refer to funds provided to financial markets by savers. The household sector is the largest supplier but loanable funds are also supplied by some government units that temporarily generate more tax revenues. Households as a group!
However, represent a net supplier of loanable funds t whereas governments and businesses are net demanders of loanable funds.
Household Demand for loanable funds
Households commonly demand loanable funds to finance housing expenditures. In addition, they finance the purchases of automobiles and household items, which results in installment debt. As the aggregate level of household income rises, so does installment debt.
Business Demand for Loanable Funds.
Businesses demand loanable funds to invest in long-term (fixed) and short-term assets.
The quantity of funds demanded by businesses depends on the number of business projects to be implemented.
Businesses evaluate a project by comparing the present value of its cash flows to its initial investment, as follows:
Government Demand for Loanable Funds
Foreign Demand for Loanable
Funds
Supply of Loanable funds
Suppliers of loanable funds are
willing to supply more funds if the interest rate (reward for supplying funds) is higher, other things being equal.
Equilibrium of Interest Rate
D>S= Interest Rate will increase.
D<S= Interest Rate will decrease.
Forecasting Interest Rates
To forecast future interest rates) the net demand for funds (ND) should be forecast:
ND = D A – SA
= (D'r + Db + Dg + Dm + Df) - (Sh + Sb + Sg + Sm + Sf)
FACTORS THAT AFFECT INTEREST RATES
Impact of Economic Growth on Interest Rates:
Changes in economic conditions cause a shift in the demand
schedule for loanable funds, which affects the equilibrium interest
rate.
Impact of Inflation on Interest Rates:
Inflation will also affect interest rate levels. The higher the inflation rate, the more interest rates are likely to rise. This occurs because lenders will demand higher interest rates as compensation for the decrease in purchasing power of the money they are paid in the future.
Fisher Effect
More than 70 years ago, Irving Fisher proposed a theory of interest rate determination that is still widely used today. It does not contradict the loanable funds theory but simply offers an additional explanation for interest rate involvements. Fisher proposed that nominal interest payments compensate for a savers in two ways.
First they compensate for a saver's reduced purchasing power
Second, they provide an additional premium to savers for forgoing present consumption. Savers are willing to forgo consumption only if they
receive a premium on their savings above the anticipated rate of inflation as shown in the following equation:
Rate of Inflation
(as measured by CPI, base
2005-06) June, 2019 May, 2019 June, 2018
Point to point 5.52% 5.63% 5.54%
Monthly Average(Twelve
Month) 5.48% 5.48% 5.78%
Impact of Monetary Policy on Interest Rates
A monetary policy that lowers interest rates and stimulates borrowing is known as an expansionary monetary policy or loose monetary policy. Conversely, a monetary policy that raises interest rates and reduces borrowing in the economy is a contractionary monetary policy or tight monetary policy.
Consider the market for loanable bank funds, shown in
Figure 14.7. The original equilibrium (E0) occurs at an interest rate of 8% and a quantity of funds loaned and borrowed of
$10 billion. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S0) to S1, leading to an equilibrium (E1) with a lower interest rate of 6% and a quantity of funds loaned of $14
billion. Conversely, a contractionary monetary policy will shift the supply of loanable funds to the left from the original
supply curve (S0) to S2, leading to an equilibrium (E2) with a higher interest rate of 10% and a quantity of funds loaned of
$8 billion.
Impact of the Budget Deficit on
Interest Rates
Impact of Foreign Flows of Funds on Interest Rates
The interest rate for a specific currency is determined by the demand for funds dominated in that currency and the supply of funds available in that currency.
