Chapter 2: Determination of Interest Rates

Invest in long-term (fixed) and short-term assets.

Businesses demand loanable funds to...

Interest Rate

Cost of Borrowing AND Return on Lending

Yes, the higher the interest rate, the more money people will invest because it will show greater returns made on the investment.

Do interest rates determine the quantity of this supply?

Demand for loanable funds = Supply of loanable funds

Equilibrium Interest Rate

i = E(INF) + iR -i = quoted rate of interest -E(INF) = expected inflation rate -iR = real interest rate

Fisher Effect *Irving Fisher

If rates rise SLOWLY, banks are generally indifferent because they are making a higher yield although there is less borrowed.

Generally, how do banks feel about interest rate growth and why?

Housing expenditures, purchases of automobiles and household items; resulting in installment debt.

Households commonly demand loanable funds to finance...

Greater; Lower More; Lower

Households would demand a _____________ quantity of loanable funds at _________ rates of interest. In other words, they are willing to borrow __________ money at ___________ rates.

It puts upward pressure on interest rates with a shift in DEMAND for loanable funds OUTWARD. -Causes people to borrow more money because there is more faith in the economy and greater rate of return.

How does Economic Growth impact interest rates?

It puts upward pressure on interest rates by shifting the supply of funds inward and demand for funds outward. *In the short-term, demand for loanable funds originally goes up because people are hesitant about prices increasing even more. Additionally, supply goes down because it costs more to produce.

How does Inflation impact interest rates?

The Fed reduces (increases) the money supply--through deposits at commercial banks or other depository institutions--it reduces (increases) the supply of loanable funds, putting upward (downward) pressure on interest rates.

How does Monetary Policy impact interest rates?

The interest rate for a certain currency is determined by the demand for funds in that currency and the supply of funds available in that currency.

How does the Foreign Flow of Funds impact interest rates?

They care a little bit when interest rates rise because there may be less growth/expansion. *Small changes are NOT the big deal, large changes present the issue.

How does the government feel about interest rate growth?

Because these policies influence economic growth and inflation, which in turn affect business demand for funds. AND Fiscal policy determines the budget deficit and therefore determines the federal government demand for funds.

How is the demand for funds in the U.S. indirectly affected by U.S. monetary and fiscal policies?

There is a shortage of loanable funds: causes interest rates to rise until additional supply of loanable funds is available to accommodate excess demand.

If aggregate demand for loanable funds increases without a corresponding increase in aggregate supply, what happens?

Somewhat sensitive to interest rates, but not as sensitive as households and businesses.

Municipal government sometimes postpone proposed expenditures if the cost of financing is too high, implying that their demand for loanable funds is...

Loanable Funds Theory

Suggests that the market interest rate is determined by the factors that control supply or demand of money.

Aggregate supply of funds

The combination of all sector supply schedules along with the supply of funds provided by the Fed's monetary policy.

Independent of Interest Rates OR Interest Inelastic

The federal government's expenditure and tax policies are generally thought to be...

Their planned expenditures cannot be completely covered by its incoming revenues from taxes and other sources. Also to pay off a deficit.

The government borrows money when...

Inversely

The quantity of U.S. loanable funds demanded by foreign governments will be _______________ related to U.S. interest rates.

Aggregate Demand for Loanable Funds

The sum of the quantities demanded by the separate sectors at any given interest rate.

Upward sloping because suppliers are willing to supply more funds if the interest rate (reward for or return on supplying funds) is higher.

The supply-of-loanable funds (the supply curve) is ___________ sloping. Why?

Budget Deficit

When the federal government enacts fiscal policies that result in more expenditures than tax revenue, the ___________ ___________ is increased.

Low

When the inflation rate is higher than anticipated, the real interest rate is relatively ______.

If the interest rate in the other country is HIGHER.

When would a country want to invest money in a different country?

Households (by putting money in the bank or 401K)

Who is the largest supplier of loanable funds?

In an effort to control U.S. economic conditions.

Why does the Fed conduct monetary policy?

To speed up (if in a recession) or slow down (if in a growth period) the economy.

Why does the Federal Reserve use monetary policy?

They have money coming in from taxes and they can print money if need be.

Why does the government borrow money regardless of the interest rate?

Higher; Rise

A ________ federal government deficit increases the quantity of loanable funds demanded at any prevailing interest rate, which causes an outward shift in the demand curve. This means that interest rates will _________.

It's own interest rates and U.S. rates.

A foreign country's demand for U.S. funds is influenced by, among other factors, the difference between...

Economic Growth -> Strong Influence on Demand Monetary Policy (changes in money supply) -> Strong Influence on Supply

In particular ______________ ___________ has a strong influence on the demand for loanable funds and changes in the ______________ __________ have a strong impact on the supply of loanable funds.

1. Economic Growth or Slowdown 2. Inflation 3. Monetary Policy 4. Budget Deficit 5. Foreign Flows of Funds

What are the 5 factors that affect interest rates?

1. Household 2. Business 3. Federal Government 4. Municipal Government 5. Foreign

What are the 5 sectors for demand of loanable funds?

The currency exchange rates can cause differences.

What can be a problem with investing overseas?

The Federal Reserve

What government entity actually contributes to this supply of loanable funds?

Aggregate Demand for Loanable Funds (-) Aggregate Supply of Loanable Funds

What is Net Demand?

When the value of the dollar is worth less and cost of goods rise.

What is inflation?

NPV > 0 OR IRR > k -Projects with a positive NPV are accepted because the present value of their benefits outweighs the costs. The required return to implement a project will be lower if interest rates are lower because the cost of borrowing funds to support the project will be lower. -IRR (Internal Rate of Return) -k (discount rate)

What is the Business Decision Rule? What does this mean?

Given a certain amount of loanable funds supplied to the market, excessive government demand for funds tends to "crowd out" the private demand (households and businesses) for funds.

What is the Crowding-Out Effect?

-Municipal: municipal bonds -Federal: Treasury securities and federal agency securities

What securities does the Municipal and Federal government issue in order to get loanable funds?

Inverse

What type of relationship is there between the interest rate and the quantity of loanable funds demanded for businesses?

Inverse

What type of relationship is there between the interest rate and the quantity of loanable funds demanded for households?