Financial institution and market ch 3

1. CHAPTER 3
INTEREST RATE DETERMINATION

2. The Nature of Interest Rates
Interest is the price paid for the use of
others money over a period of time
Borrowers must pay interest to secure
scarce loanable funds from lender for an
agreed-upon period.
The rate of interest is really a ratio of two
quantities:–
 the cost of borrowing funds
 the amount of money actually borrowed
Usually expressed on an annual percentage
basis.

3. Cont’d
Interest rates send price signals to borrowers,
lenders, savers, and investors.
 For example, higher interest rates generally
bring forth a greater volume of savings and
stimulate the lending of funds.
Lower interest rate, on the other hand, tend
to lower the flow of savings and reduce
lending activity.

4. The Theory of Interest Rates
There are several theories of interest rates and
their implications in the financial system.
Among these theories, the following four are the
common and as well popular ones:
1. The Classical theory of Interest Rates;
2. Liquidity preference theory of interest rate;
3. The Loanable Funds theory of Interest Rates;
4. The Rational Expectations theory of Interest
Rates.

5. 1. The Classical Theory of Interest Rates
The classical theory argues that rate of interest is
determined by two forces:
 The supply of savings, derived mainly from
households, business org. and government unit.
The demand capital for investment by business
sector, individuals and government units.
The classical economists believed that interest
rates in the financial market were determined by
the interplay of the supply of saving and the
demand of capital for investment.

6. Cont’d
 The Classical Theory of Interest Rates argue that
there is positive relationship between interest rate and
volume of saving.
Higher interest rates bring forth greater volume saving.
On other hand classical theory states that there is
negative relationship between demand of capital for
investment and interest rate.
At low rates of interest more investment projects
become economically viable and firms require more
funds to finance projects.
On the other hand, if the rate of interest rises to high
levels, fewer investment projects will be pursued and
less funds will be required.

7. Cont’d
The equilibrium rate of interest is determined at
the point where the quantity of savings supplied to
the market is exactly equal to the quantity of funds
demanded for investment.
At the given time the rate is probably above or
below its true equilibrium level, the market rate of
interest always moves toward its equilibrium level.

8. Cont’d
If the market rate is temporarily above
equilibrium, the volume of savings exceeds the
demand for investment capital, creating an excess
supply of savings.
Excess reserve forces Savers to offer their funds at
lower and lower rates until the market interest rate
approaches equilibrium.
If the market rate lies temporarily below
equilibrium, investment demand exceeds the
quantity of savings available.
Business firms increase the interest rate until it
approaches equilibrium point.

9. Limitations of the Classical Theory
of Interest
The central problem is that the theory ignores
several factors other than saving and investment
which affect interest rates.
The classical theory assumes that interest rates
are the principal determinant of the quantity of
savings available. but, economists recognize that
income is far more important in determining the
volume of saving.

10. 2. The Liquidity Preference Theory
Developed by during the 1930s by British
economist John M. Keynes.
It is a short-run approach to interest rate
determination because it assumes that income
remains stable.
Keynes argued that the rate of interest is a
payment for the use a scare resources-money.
Keynes also argue that even though money yield is
low or nonexistent, businesses and individuals
prefer to hold money for carrying out daily
transactions and future cash needs.

11. Keynes observed that the public demands
immediate money for three different purposes.
transactions motive : the demand for
money in order to purchase goods and
services.
 precautionary motive : To cover future
unexpected expenses.
Speculative motive: holding money to
overcome uncertainty about the
declining security prices.
cont’d

12. Cont’d
The total demand for money in the economy is
simply the sum of transactions, precautionary, and
speculative demands.
The other major element determining interest rates
in liquidity preference theory is the supply of
money.
As money supply is controlled or at least closely
regulated by government it is inelastic with
respect to the rate of interest.

13. cont’d
In the theory of liquidity preference, only two
outlets for investor fund are considered or
assumed-bonds and money (including bank
deposits).
 This theory says that if interest rates rise, the
market value of bonds paying a fixed rate of
interest will fall.
The investor would suffer a capital loss if those
bonds were converted into cash and
If the reverse is true i.e. if the interest rate is falls,
the bond price will increase i.e.(investors receive
capital gain by holding bond).

14. Cont’d
If we see the total money demand and total money
supply ; when supply of money exceeds the
quantity demanded and hence, some businesses,
households, and units of government will try to
dispose off their unwanted money balances by
purchasing bonds. The prices of bonds will rise as
a result, driving interest rates down towards the
equilibrium (i.e. to iE).

15. Cont’d
On the other hand, at rates below equilibrium the
quantity of money demanded exceeds the supply.
Some decision makers in economy will sell their
bonds to raise additional cash, driving bond down and
interest rates up toward equilibrium.
Limitation of liquidity preference theory
It is a short-run approach to interest rate
determination because it assumes that income remains
stable but in long run income is not stable
liquidity preference considers only the supply and
demand for the stock of money, whereas business,
consumer, and government demands for credit
clearly have an impact upon the cost of credit
borrowers.

16. 3. The Loanable Funds Theory
This view argues that the risk-free interest rate is
determined by the interplay of two forces:
demand for loanable funds and
the supply of loanable funds.
The demand for loanable funds consists of :
• Credit demands from domestic businesses;
• Consumers;
• units of government and
• borrowing in the domestic market by
foreigners. Like Foreign banks,
corporations, and foreign governments

17. Cont’d
The supply of loanable funds stems from four
sources:
• Domestic savings,
• Hoarding demand for money, either positive
hoarding, which reduces volume of loanable
funds or negative hoarding/dishoarding,
which increases volume of loanable funds,
• Money creation by the banking system, and
• Lending in the domestic market by foreign
individuals & institutions.

18. The difference between the public's total demand for
money and the money supply is known as hoarding.
When the public's demand for money exceeds the supply,
positive hoarding of money takes place as individuals and
businesses attempt to increase their money holdings.
When the public's demand for money is less than the
supply available, negative hoarding (also called
dishoarding) occurs.
 The two forces of supply & demand for loanable
funds determine not only the volume of lending &
borrowing going in the economy, but also the rate
of interest.

19. Cont’d
4. The Rational Expectations Theory of
Interest Rates
The rational expectations theory builds upon a
growing body of researches.
Rational expectations theory developed on the
bases that the interest rate increase or decrease
in the economy depends on expectation of
rational investors about future based on current
information.
This theory evidence that the money and capital
markets which reacts to new information
affects interest rates & security prices.

20. Cont’d
This theory states that , if the money & capital
markets are highly efficient interest rates will
always be at or very near their equilibrium levels.
Any deviation from the equilibrium rate level
dictated by demand & supply forces will be almost
instantly eliminated.
Interest rate fluctuations around equilibrium are
likely to be random.

21. Cont’d
Moreover, knowledge of past interest rates
will not be a reliable guide to where those
rates are likely to be today or in the future.
The rational expectations theory also
suggests that interest rates do not change
permanently from their current equilibrium
levels unless new information appears.

22. The Structure of Interest Rates
There is no one interest rate in any economy;
rather, there is a structure of interest rates.
The Base of Interest Rate:
 Market participants throughout the world view
Treasury bill as having no credit risk.
 As a result, the interest rates on Treasury
securities have served as the benchmark interest
or basis of interest rate throughout international
financial market.

23. Contn’d
 The Risk Premium:
A risk premium reflects the additional risks the
investor faces by acquiring non treasury bill
securities.
Interest Rate = Base Interest Rate + Risk Premium
The factors that affect risk premium of securities are:
1. The issuer’s perceived creditworthiness
Credit risk refers to the risk that the issuer of a
debt obligation may be unable to make timely
payment of interest and/or the principal amount
when it is due.
Most market participants rely primarily on
commercial rating companies (credit rating
companies) to assess the default risk of an issuer.

24. Cont’d
These companies perform credit analyses and
express their conclusions by a system of ratings.
E.G Moody’s Investors Service by (Aaa)
Standard & Poor’s Corporation by (AAA)
Fitch Ratings( In most cases similar with S & p)

25. cont’d
The highest-grade bonds are designated by
Moody’s by the symbol Aaa, and by S&P and
Fitch by the symbol AAA.
The next highest grade is denoted by the
symbol Aa (Moody’s) or AA (S&P and Fitch);
For the third grade all rating systems use A.
The next three grades are Baa or BBB, Ba or
BB, and B, respectively.
There are also C and D grades.

26. End of chapter three