Money

Lecture#3

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Banking

What are the factors that establish the level of interest rates in the
economy and cause it to change? What is the effect of inflation on the
level of interest rates and how investors and financial institutions
forecast interest rate movements? But first what are interest rates?
WHAT ARE INTEREST RATES?

Interest rates are the price of borrowing money for the use of its
purchasing power. (It is a rental price of money).

To borrowers, interest is the penalty paid for consuming income

before it is earned.

To lenders, interest is the reward for postponing (delaying)

current consumption until the maturity of the loan.

Like other prices, interest rates serve an allocative function in

the economy. They allocate funds between surplus spending
units (SSUs) and deficit spending units (DSUs) and between
financial markets.

For SSUs, the higher the rate of interest, the greater the reward
for delaying current consumption and thus the greater the
amount of savings in the economy.

For DSUs the higher the yield (interest rate) paid on a particular
security, the higher the cost of money.

Thus, SSUs want to buy financial claims with the higher returns
whereas DSUs want to sell financial claims at the lowest possible
interest rate. So how interest rates are determined?

THE REAL RATE OF INTEREST

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.

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Investment is negatively related to interest rate. That is, other

things remaining equal, the higher the interest rate the lower the
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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
investment, and
- Upward sloping supply curve of desired saving.

desired

The interaction of these two determines the rate of 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 equilibrium rate of interest (r*) is achieved when

desired saving (s*) by savers equals desired investment (I*) by
producers across all economic units.

This equilibrium rate 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.
Interest rate

Desired Savings (DS)

r*

Desired Investments (DI)

Saving & investment
*

S =I

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THE LOANABLE FUNDS THEORY & INTEREST RATES

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 shortrun.

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.

Buying of financial claims to earn interest represent the supply of

loanable fund.

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 equilibrium interest 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.

Therefore:
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If interest rate is at r1 (below equilibrium), shortage of loanable

funds exist, which force the interest up. And

If interest rate is at r2 (above equilibrium), surplus of loanable funds

exist, which force the interest rate down.

Interest rate
SL
r2
r0
r1
DL
Loanable funds
Q0

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 equilibrium occurs.

What are the factors other than the interest rate?

FACTORS AFFECTING SUPPLY OF LOANABLE FUNDS
1. 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 equilibrium with lower
interest rate and higher equilibrium quantity.
2. CHANGE IN THE INCOME TAX:

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A decrease in income tax increase saving. Thus, the supply of

loanable funds increases, shifting the SL curve to the right,
decreasing r0 and increasing Q0.
3. CHANGES IN GOVERNMENT
SURPLUS POSITION:

BUDGET

FROM

DEFICIT

TO

Reduced government expenditure increases government savings,

thus shifts the SL curve to the right.

4. 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.
5. 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.
6. CHANGES IN BUSINESS SAVING:
An increase in business saving of course increases supply of
loanable funds and SL curve shift to the right.
FACTORS AFFECTING DEMAND FOR LOANABLE FUNDS
1. 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 equilibrium
quantity.
2. CHANGES IN GOVERNMENT BUDGET FROM SURPLUS TO
DEFICIT POSITION:
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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.
3. 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.
SOURCE OF SUPPLY LOANABLE FUNDS:
a. Consumer savings
b. Business savings
c. Government savings
d. Central bank, changing quantity of money.
SOURCE OF DEMAND LONABLE FUNDS:
a. Business investment
b. Consumer credit purchase
c. Government budget deficit
Measuring Interest Rates
Present Value
The concept of present value (or present discounted value) is
based on the commonsense notion that a dollar paid to you one year
from now is less valuable to you than a dollar paid to you today: This
notion is true because you can deposit a dollar in a savings account
that earns interest and have more than a dollar in one year. The
process of calculating todays value of dollars received in the future, as
we have done above, is called discounting the future. We can
generalize this process by writing todays (present) value of $100 as
PV, the future value of $133 as FV, and replacing 0.10 (the 10%
interest rate) by i. This leads to the following formula:
PV =

FV
(1 + i)

Four Types of Credit Market Instruments

1. Simple Loan
2. Fixed payment loan
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3. Coupon bond
4. Discount bond
Simple Loan.
A simple loan is one in which the lender provides the borrower with an amount of
funds, which must be repaid to the lender at the maturity date along with an
additional payment for the interest. Many money market instruments are of this
type: for example, commercial loans to businesses.

Using the concept of present value, the yield to maturity on a simple loan is
easy to calculate. For the one-year loan we discussed, todays value is $100, and
the payments in one years time would be $110 (the repayment of $100 plus the
interest payment of $10). We can use this information to solve for the yield to
maturity i by recognizing that the present value of the future payments must
equal todays value of a loan. Making todays value of the loan ($100) equal to
the present value of the $110 payment in a year (using Equation 1) gives us:

Solving for i,

This calculation of the yield to maturity should look familiar, because it equals
the interest payment of $10 divided by the loan amount of $100; that is, it equals
the simple interest rate on the loan. An important point to recognize is that for
simple loans, the simple interest rate equals the yield to maturity. Hence the
same term i is used to denote both the yield to maturity and the simple interest
rate.
Fixed-payment loan

A fixed-payment loan (which is also called a fully amortized loan)

in which the lender provides the borrower with an amount of funds,
which must be repaid by making the same payment every period (such
as a month), consisting of part of the principal and interest for a set
number of years. For example, if you borrowed $1,000, a fixedpayment loan might require you to pay $126 every year for 25 years.
Installment loans (such as auto loans) and mortgages are frequently of
the fixed-payment type.
Coupon Bond

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A coupon bond pays the owner of the bond a fixed interest payment
(coupon payment) every year until the maturity date, when a specified
final amount (face value or par value) is repaid. The coupon
payment is so named because the bondholder used to obtain payment
by clipping a coupon off the bond and sending it to the bond issuer,
who then sent the payment to the holder. Nowadays, it is no longer
necessary to send in coupons to receive these payments. A coupon
bond with $1,000 face value, for example, might pay you a coupon
payment of $100 per year for ten years, and at the maturity date
repays you the face value amount of $1,000. (The face value of a bond
is usually in $1,000 increments.)
A coupon bond is identified by three pieces of information. First is the
corporation or government agency that issues the bond. Second is the
maturity date of the bond. Third is the bonds coupon rate, the dollar
amount of the yearly coupon payment expressed as a percentage of
the face value of the bond. In our example, the coupon bond has a
yearly coupon payment of $100 and a face value of $1,000. The
coupon rate is then $100/$1,000 _ 0.10, or 10%. Capital market
instruments such as U.S. Treasury bonds and notes and corporate
bonds are examples of coupon bonds.

When the coupon bond is priced at its face value, the yield to
maturity equals the coupon rate.

The price of a coupon bond and the yield to maturity are negatively
related; that is, as the yield to maturity rises, the price of the bond
falls. As the yield to maturity falls, the price of the bond rises.

The yield to maturity is greater than the coupon rate when the bond
price is below its face value.

It is straightforward to show that the bond price and the yield to

maturity are negatively related. As i, the yield to maturity, rise, all
denominators in the bond price formula must necessarily rise. Hence a
rise in the interest rate as measured by the yield to maturity means
that the price of the bond must fall. Another way to explain why the
bond price falls when the interest rises is that a higher interest rate
implies that the future coupon payments and final payment are worth
less when discounted back to the present; hence the price of the bond
must be lower.
Discount bond

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A discount bond (also called a zero-coupon bond) is bought at a

price below its face value (at a discount), and the face value is repaid
at the maturity date. Unlike a coupon bond, a discount bond does not
make any interest payments; it just pays off the face value. For
example, a discount bond with a face value of $1,000 might be bought
for $900; in a years time the owner would be repaid the face value of
$1,000. U.S. Treasury bills, U.S. savings bonds, and long-term zerocoupon bonds are examples of discount bonds. The formula to
calculate the yield on a discount bond is as under:
YT

SP PP 365

PP
n

Computing the Yield of a Discount bond

An investor purchases a 91-day T-bill for $97.82. If the T-bill is held to maturity, what is
the yield the investor would earn?
SP PP 365

PP
n
100 97.82 365

97.82
91
8.94%

YT

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