presentation chapter 5

chapter 5

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

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 interest rate
  Risk-free rate of interest
  Opportunity cost of holding cash
  Closest real-world equivalent is government bonds rate
  

The classical theory is one of the oldest interest rate theories

• Rate of interest is determined by the balance of two forces
  Supply of savings, derived mainly from households
  Demand for investment capital, coming mainly from the business sector

Current household savings
Abstinence from consumption spending
Difference between current income and current consumption expenditures

Individuals have a time preference for current consumption
Prefer current enjoyment of goods and services over future enjoyment
Payment of interest is a reward for waiting

Higher rates encourage the substitution of current saving for current consumption

wealth effect
Timing and amount of savings
Current income and expected future income
Desired savings target
Propensity to save
Wealth

Wealth effect
Greater wealth tends to raise consumption
Strong during the late 1990s
Stock market and housing boom
Personal savings rate was negative

The Classical Theory of Interest Rates
Business savings
Savings balances in form of retained earnings
Primary financing for business investment
Principally determined by profits
Interest rates also impact savings

Government savings
When the government has a budget surplus
Major determinants
Income flows in the economy
Pacing of government spending
Rates impact cost of government debt

Demand for investment funds
Primarily for businesses
Gross business investment equals the sum of replacement investment and net investment
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

The demand for investment funds … continued
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.
Another method of investment analysis is the net present value (NPV) approach

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
Income and wealth are more important than interest rates in determining savings
Traditionally businesses primary borrower
Now consumers major borrowers
Now governments major borrowers


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

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
There are three elements of demand for cash balances

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
Transactions demand in earlier theory
Dependent on level of national income
Dependent on business sales
Dependent on prices

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

Speculative motive
Demand due to uncertainty in future bond prices
Change in interest rates
Changes bond prices
Demand for cash balances substitute for bonds
High interest rates lead to high opportunity cost of holding cash

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

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
Useful insights
Rational at times to hoard or dishoard cash
Shows how central banks impact the markets

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

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), 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 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

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 supply of loanable funds
… continued
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
Foreign lending sensitive to the spread between domestic and foreign

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 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.

Businesses and individuals
Rational agents
Make optimal use of resources to maximize returns
Tend to make unbiased forecasts of future asset prices, interest rates, and other variables
Under rational expectations, money and capital markets are highly efficient

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

Knowledge of past interest rates not reliable forecast of future rates
Optimal forecast equals current interest rate
Changes only when information changes expectations

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 meet at equilibrium
Lose the relation between interest rates and current economic changes

The Rational Expectations Theory of Interest

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

Chapter Review
Introduction: interest rates and the price of credit
Functions of the interest rate in the economy
The classical theory of interest rates
Savings by households, business firms and governments
The demand for investment funds
The equilibrium interest rate
Limitations of the classical theory

The liquidity preference or cash balances theory of interest rates
The demand for liquidity
The supply of money (cash balances)
The equilibrium interest rate
Limitations of the liquidity preference theory

The loanable funds theory of interest
The demand for loanable funds
The supply of loanable funds
The equilibrium interest rate
The rational expectations theory of interest