![Insights
Provides some useful insights into
investor behavior and the influence of
government policy on the economy and
financial system
It is rational at certain times for the public
to hoard money (cash balances] and at
other times to dis-hoard spend unwanted
cash.](https://image.slidesharecdn.com/intrateinfsystem1-220828150859-41c13004/85/Int-Rate-in-Fsystem1-ppt-44-320.jpg)
Int Rate in Fsystem1.ppt
- 1. Chapter 5 Interest Rates in the Financial System
- 2. 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. Some refer to this as the price of credit.
- 3. Introduction The rate of interest is a ratio of the money cost of borrowing divided by the money actually borrowed. Interest rates send price signals to borrowers, lenders, savers, and investors. Whether higher interest rates increase or decrease savings and investment depends on the relative strength of its effect on supply and demand factors.
- 4. Functions of the Interest Rate in the Economy Rate of Interest Helps guarantee that current savings flow into investment to promote economic growth Generally allocates the available supply of credit to investment projects with the highest expected returns Balances the supply of money with the public’s demand for money Tool of government policy through its influence on the volume of saving and investment.
- 5. The Interest Rate Common reference to “the interest rate” Multiple rates in economy Even securities by the same borrower can have differing rates Focus on forces that impact all rates Assume a single fundamental rate Pure or Risk-free rate of interest Opportunity cost of holding idle cash Closest real-world equivalent is government bonds rate
- 6. The Classical Theory of Interest Rates The classical theory is one of the oldest interest rate theories. Determinants of pure or risk-free interest rate. Long term. Developed during 18th and 19th century by a number of British Economists. Elaborated by British Economist Irving Fisher (1930)
- 7. The Classical Theory of Interest Rates Rate of interest is determined by the balance of two forces 1. Supply of savings, derived mainly from households 2. Demand for investment capital, coming mainly from the business sector
- 8. Savings by Household Most savings in modern industrialized economies is carried out by Individuals and Families. Current household savings is Abstinence from consumption spending Difference between current income and current consumption expenditures
- 9. In making the decision on the timing and amount of savings to be done. House-holds typically consider several factors: 1. the size of current and expected long-term income 2. the desired savings target. and 3. the desired proportion of income to be set aside in the form of savings (.i.e.. the propensity to save) Generally volume of HH savings rises with income.
- 10. Although income level dominate savings decisions, Interest rate also play an important role. It affect an individual’s choice between current consumption and saving for future consumption.
- 11. Classical Theory assumes that Individuals have a time preference for current consumption Prefer current enjoyment of goods and services over future enjoyment the only way to encourage an individual or family to consume less now and save more is to offer a higher rate of interest on current savings.
- 12. When interest rates rises, people tend to save more reducing their consumption & vice versa. Payment of interest is a reward for waiting- the postponement of current consumption in favor of greater future consumption Higher rates encourage the substitution of current saving for current consumption. This substitution effect calls for a positive relationship between interest rate and volume of savings.
- 13. The Substitution Effect Relating Savings and Interest Rates Interest Rate Current Saving r1 S1 r2 S2
- 14. Savings by Business Firms Businesses also save and direct a portion of their savings into the financial markets to purchase securities and make loans. Most businesses hold savings balances in the form of retained earnings. The volume of business saving depends on two key factors: the level of business profits and the dividend policies of corporations. 5-14
- 15. Dividend policies of major corporations do not change very often. So, the critical clement in determining the amount of business savings is the level of business profits. If profits are expected to rise, businesses will be able to draw more heavily on earnings retained in the firm and less heavily on the money and capital market for funds
- 16. It result in reduction in the demand for credit and a tendency toward lower interest rate. On the other hand, when profits fall but firms do not cut back on their investment plans, they are forced to rely on money and capital market for investment funds. The demand for credit rises, and interest rates rises as well.
- 17. Although the principal determinant of business saving is profits, interest rate also play a major role in the decision of what proportion of current operating costs and long -term investment expenditures should be financed internally and what proportion externally. Higher interest rates in the money and capital market encourage firms to use internally generated funds more heavily in financing projects.
- 18. Government Savings When the government has a budget surplus Major determinants Income flows in the economy Pacing of government spending. Interest Rate are not a key factor.
- 19. Demand for investment funds Primarily for businesses Businesses require huge amounts of funds each year to purchase equipment, machinery and inventories and to support the construction of new buildings and other physical facilities Gross business investment equals the sum of replacement investment and net investment
- 20. Replacement investments are more predictible Grows at a more even rate than net investment. Financed exclusively from inside the firm and follows a routine pattern based on depreciation formula.
- 21. Net investment depends on Business community’s outlook for future sales. Changes in technology Industrial Capacity Cost of raising fund. Those factors are subject to frequent change, so net investment is volatile.
- 22. Net investment because of its size and volatility, is a driving force in the economy. Changes in net investment are closely linked to fluctuations in the nation’s output of goods and services, employment, and prices. A significant decline in net investment frequently leads to a business recession, a decline in productivity, and a rise in unemployment and vice versa
- 23. The Investment Decision Making Process Complex and depends on host of qualitative and quantitative factors Different methods are followed for financial viability including NPV, IRR, PI etc. One 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
- 24. The firm usually compares each project’s expected internal return with the cost of raising capital (i.e. interest rate) in the money and capital markets to finance the project. As credit becomes scarcer and more expensive, the cost of borrowed capital rises, eliminating some investment projects from consideration.
- 25. 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 = n n r NCF ... r NCF r NCF 1 1 1 2 2 1 1 Another method of investment analysis is the net present value (NPV) approach.
- 26. The Cost of Capital and the Business Investment Decision A 15% B 12% C 10% D 8% E 7% Dollar Cost of Investment Projects Expected Internal Rates of Return on Alternative Investment Projects Cost of Capital Funds = 10% C 10% D 8% E 7% – acceptable – acceptable – indifferent unprofitable unprofitable
- 27. The Investment Demand Schedule In the Classical Theory of Interest Rates r2 Interest Rate Investment Spending r1 I1 I2
- 28. The Equilibrium Rate of Interest In the Classical Theory Rate of interest (% per annum) Volume of savings & investment ($billions) rE QE = $200 billion Demand for Investment Volume of Savings E S S D D
- 29. Limitations Ignores factors other than savings and investment that affect interest rates For example, many financial institutions can “create” money today by making loans Repaying the loan “destroys” money
- 30. Income and wealth are more important than interest rates in determining savings Traditionally businesses primary borrower Now consumers major borrowers Now governments major borrowers
- 31. The Liquidity Preference (Cash Balances) Theory of Interest Rates The liquidity preference (or cash balances) theory of interest rates Short-term theory Developed for explaining near-term changes in interest rates More relevant for policymakers Developed by Jhon Maynard Keynes (1936)
- 32. Keynes argued that the rate of interest is really a payment for the use of a scarce resource money Businesses and individuals prefer to hold money for carrying out daily transactions and also as a precaution against future cash needs. Interest rates, therefore. are the price that must be paid to induce money holders to surrender a perfectly liquid asset and hold other assets that carry more risk
- 33. The Liquidity Preference (Cash Balances) Theory of Interest Rates Rate of interest is the payment For the use of their scarce resource (liquidity) By those who demand liquidity Assumed outlet for funds Bonds Cash Balances (including bank deposit) There are three elements of demand for cash balances
- 34. Motives for holding money Transactions motive Precautionary motive Speculative motive
- 35. Transactions motive Economic units do not have a perfect balance of inflows and outflows Hold liquidity for purchase of goods and services Not overly sensitive to interest rates 5-35
- 36. Precautionary motive Cannot predict future expenditures precisely Cope with future emergencies Cover potential extraordinary expenses e.g. unanticipated medical expense Greater in times of economic uncertainty Not overly sensitive to interest rate movements
- 37. Speculative motive Demand due to uncertainty in future bond prices Change in interest rates Changes bond prices Demand for cash balances substitute for bonds There is a negative relationship between speculative demand for money & interest rate.
- 38. Keynes assumed that money demanded for transactions and precautionary purposes is dependent on the level of national income, business sales, and prices. Money demand for precautionary and transaction purposes to be fixed in the short term. In the longer term, however. transactions and precautionary demands change as income changes.
- 39. Speculative Demand for Money or Cash Balances
- 41. The Supply of Money Modern governments control or closely regulate money supply Decisions concerning the size of the money supply presumably guided by the public welfare So assume the supply of money (cash balances) is inelastic with respect to interest rates Represented by a vertical supply curve in the equilibrium
- 42. Total Demand for Money or Cash Balances And the Equilibrium Rate of Interest 5-42
- 43. The Equilibrium Rate of Interest in Liquidity Preference Theory The interaction of the total demand for and the supply of money determines the equilibrium rate of interest in the short run. Quantity of money demanded by public equals supply provided by government If the supply exceeds quantity demanded at current interest rates Buy bonds with excess funds Decrease cash balances Increase bond prices and lower interest rates
- 44. Insights Provides some useful insights into investor behavior and the influence of government policy on the economy and financial system It is rational at certain times for the public to hoard money (cash balances] and at other times to dis-hoard spend unwanted cash.
- 45. If the public disposes of some of its cash by purchasing securities, this action increases the quantity of loanable funds available from the financial markets. Other things being equal, interest rates will fall
- 46. On the other hand, if the public tries to "hoard" more money, (expanding its cash balances by selling securities less money will be available for loans. Then interest rate will rise.
- 47. Limitations The liquidity preference theory is a short- term theory Assumption that income remains stable does not hold in the long-term Only the supply and demand for money is considered Fails to consider the supply and demand for credit by all actors in financial system businesses, households, and governments
- 48. The Loanable Funds Theory of Interest Loanable funds theory Most popular practitioner theory Risk-free interest rate is determined by the interplay of two forces the demand for credit (loanable funds) from, 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
- 49. 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
- 50. Consumer (household) demand for Loanable fund While borrowing, consumers are not particularly responsive to the rate of interest rather focus principally on non price term of loan. Maturity, down-payment, maturity of loan, size of installment payment are important factor. Consumer (household) demand is relatively inelastic with respect to the rate of interest.
- 51. Domestic business demand for Loanable Fund More responsive to interest rate change. Domestic business demand increases as the rate of interest falls. Consider Cost of fund vs Expected rate of return (IRR)
- 52. Government demand for Loanable Fund Government demand does not depend significantly upon the level of interest rates. Federal Govt. decision on spending and borrowing are made by Congress in response to social needs and public welfare. (not rate of interest) Moreover, they have the power to tax and create money to pay its debt. So, Demand is inelastic.
- 53. Local and State Govt demand is slightly interest elastic. Many Local Govt are limited in their borrowing activities by legal interest rate ceilings. When open market rate rise, some local and State Govt are prevented from offering their securities to the public.
- 54. Foreign demand for Loanable Fund Foreign demand is sensitive to the spread between domestic and foreign interest rates. If domestic rate decline relative to foreign rates, foreign borrowers will eager to borrow more from domestic market and less from abroad.
- 55. Interest Rate Amount of Loanable Funds Total Demand = Dconsumer + Dbusiness + Dgovernment + Dforeign Total Demand for Loanable Funds (Credit)
- 56. The supply of loanable funds At least four different sources 1. Domestic savings by business, consumers and Govt. 2. Dishoarding of Excess money balances held by public 3. Creation of money by domestic banking system. 4. Lending to domestic borrowers by foreigners.
- 57. Domestic savings. Principle source of Loanable fund. Mainly done by household, sometimes Business, and rarely Govt. Have to consider: Income Effect Substitution Effect Wealth Effect ( Also, opposite effect)
- 58. The net effect of income, substitution, and wealth effects is a relatively interest-inelastic supply of savings curve.
- 59. Dishoarding of money balances. Difference between public total demand for money and money supply is known as hoarding. When public’s demand for cash balance exceeds the supply, positive hoarding of money takes place. Hoarding reduces the volume of Loanable funds available in the Financial marketplace.
- 60. When public demand for money is less than supply available, negative hoarding occurs When individuals and businesses dispose of their excess cash holdings, the supply of loanable funds available to others is increased.
- 61. Creation of credit by the domestic banking system Commercial banks and nonbank thrift institutions offering payments accounts can create credit by lending and investing excess reserves. It represents an additional source of loanable funds which must be added to the amount of savings and dis-hoarding of money balances to derive the total amount of Loanable fund in the economy.
- 62. Foreign lending It is sensitive to the spread between domestic and foreign rates
- 63. The Loanable Funds Theory of Interest Total Supply of Loanable Funds (Credit) Interest Rate Amount of Loanable Funds Total Supply = domestic savings + newly created money + foreign lending – hoarding demand
- 64. The Loanable Funds Theory of Interest
- 65. This is a partial equilibrium position. Here interest rate is affected by conditions in both the domestic and world economies.
- 66. 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
- 67. 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.
- 68. Changes in the Demand for and Supply of Loanable Funds
- 69. Changes in the Demand for and Supply of Loanable Funds
- 70. The Rational Expectations Theory of Interest 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.
- 71. Assumptions and Conclusions 1. The price of securities and interest rate should reflect all available information and market uses all of this information to establish a probability distribution of expected future price and return. 2. Changes in rates and security prices are correlated only with unanticipated, not anticipated information.
- 72. 3. The correlation between rates of return in successive time periods is zero. 4. No unexploited opportunities for profit (above a normal return) can be found in the securities’ market. 5. Transactions and storage cost for securities are negligible and information costs are small relative to the value of securities are traded.
- 73. 6. Expectations concerning future security prices and interest rates are formed rationally and efficiently.
- 74. Businesses and individuals are Rational agents Form expectations about distribution of future security prices & interest rates that does not differ from optimal forecast. Make optimal use of resources to maximize returns
- 75. Tend to make unbiased forecasts of future asset prices, interest rates, and other variables. Make no systematic forecasting error, identifies past error and rectifies it.
- 76. Under rational expectations, money and capital markets are highly efficient. So, interest rates will always be at or very near their equilibrium levels. Any deviations dictated by demand and supply forces will be almost instantly eliminated.
- 77. Security traders hoping to earn windfall profits from guessing are unlikely to be successful in the long run. Moreover, knowledge of past interest rate will not be a reliable forecast in the future. Indeed, according to the theory, in the absence of new information, the optimal forecast of next period’s interest rate would probably be equal to the current period interest rate i.e., {E(r t+1) = rt)}
- 78. Because, there is no particular reason for next period’s interest rate to be either higher or lower than today’s interest rate until new information causes market participants to revise their expectations. Old news will not affect today’s interest rates because those rates have already impounded the old news.
- 79. Interest rates will change only if entirely new and unexpected information appears Direction of change depends on the public’s current set of expectations New equilibrium based on revised expectations Speculators unlikely to consistently earn windfall profits from estimating interest rates
- 80. Knowledge of past interest rates not reliable forecast of future rates Optimal forecast equals current interest rate Changes only when information changes expectations
- 81. Illustration of Federal Govt case
- 82. Expected Demand for and Supply of Loanable Funds Can modify the loanable funds theory equilibrium Use expected demand for loanable funds, instead of current demand Use expected supply for loanable funds, instead of current supply The two meets at equilibrium Lose the relation between interest rates and current economic changes
- 83. Expected Demand for and Supply of Loanable Funds
- 84. The thoery argues that forecasting interest rate requires knowledge of public’s current set of expectations. If new information is sufficient to alter those expectations, interest rate must change. It creates problem for Govt policymakers. So, theorist prefer “ Rate Hedging”
- 85. Research Evidence Mishkin (1978) and Philips and Pippenger (1976) Rozeff (1974) Engel and Frankel (1984)
- 86. Limitations Do not know very much about how the public forms its expectations The cost of gathering and analyzing information relevant to the pricing of assets is not always negligible Not all interest rates and security prices appear to display the kind of behavior implied by the theory.