Financial Markets - Chapter 2

Is there only one or "multiple" interest rates at once?

"Multiple", in reality there are several different interest rates at once because some borrowers pay a higher rate than others

Fed reduces the money supply

(when prices rise) Reduces the supply of loanable funds

Foreign demand for loanable funds

-A country's demand for foreign funds depends on the interest rate differential between the two. -The greater the differential, the greater the demand for foreign funds. -The quantity of U.S. loanable funds demanded by foreign governments will be inversely related to U.S. interest rates.

Household demand can be forecast by:

-Assessing consumer credit data to determine borrowing capacity -Assessing factors that affect the earning power of households

Factors that affect interest rate movements:

-Changes in economic growth (strong influence on demand) -Inflation -Budget deficit -Foreign interest rates -Money supply (strong impact on the supply of loanable funds)

Future Demand for Loanable Funds depends on future

-Foreign demand for U.S. funds -Household demand for funds -Business demand for funds -Government demand for funds

Future Supply of Loanable Funds depends on:

-Future supply by households and others -Future foreign supply of loanable funds in the U.S.

Government demand for loanable funds

-Governments demand loanable funds when planned expenditures are not covered by incoming revenues. -Government demand is said to be interest inelastic: insensitive to interest rates. Expenditures and tax policies are independent of the level of interest rates.

Fed increases money supply

-Increases supply of loanable funds -decreases i (downward pressure)

Fed increases money supply

-Money-supply curve shifts right -Interest rate falls -At any given price level •Increase in quantity demanded of goods and services -Aggregate-demand curve shifts right

Fisher Effect

-Nominal interest payments compensate for a saver's reduced purchasing power AND add an additional premium to savers for forgoing present consumption. -Savers are willing to forgo consumption only if they receive a premium on their savings above the anticipated rate of inflation i = E(INF) + i[r] i = nominal or quoted rate of interest E(INF) = expected inflation rate i[r] = real interest rate

Financial Reform Act of 2010

-Rating agencies must establish internal controls - Credit rating agencies are subject to oversight by a newly established Office of Credit Ratings

Factors Affecting Demand for loanable funds

1. Utility derived from product or service 2. Restrictiveness of non-price conditions 3. Economic conditions

Factors affecting supply for loanable funds

1. Wealth 2. Risk 3. Spending needs 4. Monetary Expansion 5. Economic Conditions

The British government gets financing by issuing British securities to U.S. investors. What does this represent?

British (foreign) demand for U.S. funds

Effects of the Fed

By affecting the supply of loanable funds, the Fed's monetary policy affects interest rates.

NPV for projects to be accepted

A net NPV over 0 (positive)

Primary forces behind a change in the supply of savings provided by households

Economic conditions

Interest rate movements have an indirect effect on market value of:

Equity securities (capital market stock [common/preferred])

(shifts in (business) demand curve) Economic conditions become more favorable/improve

Increase in demand will result in outward shift (to the right) -Because more projects will be accepted (higher expected returns) and therefore demand loans

_________ attempt to anticipate interest rate movements so that they can monitor the potential cost of borrowing or the potential return from investing in various debt securities

Individuals

Federal Government demand for loans

Interest-Inelastic: insensitive to interest rates The federal government's expenditure and tax policies are generally thought to be independent of interest rates.

Household demand for loanable funds

Inverse relationship between the interest rate and the quantity of loanable funds demanded. Demand for: financing housing and automobile expenditures

What can explain why interest rates/debt securities vary between countries?

Loanable Funds Theory (along with other concepts)

_________ attempt to anticipate interest rate movements and restructure their assets and liabilities to capitalize on their expectations

Managers of Financial Institutions

Loanable Funds Theory can explain:

Movements in the general level of interest rates in a particular country

Net Demand (ND)

ND = D[a] - S[a] Aggregate demand - aggregate supply

Budget deficit increases causes

Outward shift to the demand curve (to the right) -increases the quantity of loanable funds demanded at any prevailing interest rate

Impacts of economic growth on interest rates

Puts upward pressure on interest rates by shifting demand for loanable funds outward

impact of inflation on interest rates

Puts upward pressure on interest rates by shifting supply of funds inward and demand for funds outward

Fed reduces money supply

Reduces the supply of loanable funds Puts upward pressure on interest rates (when prices rise)

Interest rate

Reflects rate of return that a creditor receives when lending money ...OR...... the rate a borrower pays when borrowing money ............................................................ Movements affect the value of most financial institutions Influence the cost of funds to depository institutions

Why would hardly any amount of savings be supplied at low interest rate levels?

Relatively high inflation levels encourages households to spend more disposable income rather than save

If aggregate demand for loanable funds increases without a corresponding increase in aggregate supply, there will be a:

SHORTAGE of loanable funds ...Interest rates will rise until there are funds available

Demand curve impact - economic slow down

Shift D down and to left

Interest rate below i

Shortage of loanable funds

Municipal Government demand for loans

Somewhat sensitive to interest rates Will sometimes postpone expenditures if the cost of financing will be too high due to high rates

Tax rate on interest income is increased:

Supply curve will shift inward, as households will save less at each possible interest rate level

Interest rate above rate i

Surplus of loanable funds

Because of large budget deficits in recent years, __________________ is a major participant in the demand for loanable funds.

The U.S. Government -A higher federal government deficit increases the quantity of loanable funds demanded at any prevailing interest rate

Forecasting

The factors that influence the supply and demand of funds can and are forecasted to help predict interest rates

Demand for funds in U.S. is indirectly affected by:

U.S. Monetary and fiscal policies, because these policies influence economic growth and inflation

U.S. Inflation rate expected to increase

Upward shift (to the left) to the supply curve -Increase to i -Decrease to quantity supplied

Impact of Monetary Policy on Interest Rates

When the Fed reduces (increases) the money supply, it reduces (increases) the supply of loanable funds, putting upward (downward) pressure on interest rates.

If the demand schedule of any sector changes, the aggregate demand schedule will be:

affected

Business demand can be forecast by:

assessing future plans for corporate expansion and the future state of the economy

Aggregate supply of loanable funds

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

Business evaluation of a project

comparing present value of its cash flows to its initial investment NPV = = TN / (TN + FN) (look more)

Interest rate movements have a direct effect on market value of:

debt securities (money market securities, bonds, and mortgages)

rate that equates the aggregate demand for funds with the aggregate supply of loanable funds

equilibrium point

Relationship between dollars saved/real interest rate

positive relationship between the dollars saved and the real interest rate

The difference between the nominal interest rate and the expected inflation rate is the __________

real interest rate, real return to a saver after adjusting for the reduced purchasing power real interest rate adjusts for the expected rate of inflation Inflation: 3% nominal interest rate: 4% real interest rate: 1%

On a graph, at any point below i, there will be a:

shortage of loanable funds

Loanable Funds Theory

suggests that the market interest rate is determined by the factors that control supply of and demand for loanable funds -commonly used to explain interest rate movements -especially useful in explaining movements in the general interest level of different countries

Tax rate on interest income is reduced:

supply curve will shift outward, as households will save more funds at each possible interest rate level

_________ schedule may also change in response to economic growth, but it is difficult to know which direction it will shift

supply-of-loanable funds

Purchasing domestic securities is:

supplying funds to their domestic market(s)

On a graph, at any point above i, there will be a:

surplus of loanable funds

If aggregate supply of loanable funds increases without a corresponding increase in aggregate demand, there will be a:

surplus of loanable funds ...interest rates will fall until the quantity of loans supplied no longer exceeds the quantity of funds demanded

______ issue treasure securities and federal agency securities

the federal government and its' agencies

Fiscal policy determines the budget deficit and therefore determines:

the federal government demand for funds

Equilibrium interest rate

the interest rate at which the quantity of loanable funds supplied equals the quantity of loanable funds demanded

Aggregate Demand for loanable funds

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

Crowding-out effect

excessive government demand for funds tends to "crowd out" the private demand for funds -government will sometimes do whatever is necessary (disregarding interest rates)

although ______ play a critical role in transferring funds, they are not the ultimate suppliers of funds

financial institutions

Supply of funds provided to the U.S. by foreign investors is influenced by:

foreign economic conditions, including foreign interest rates

Fed. Government demand can be forecast by:

future state of economy - affects tax revenues/amount of unemployment compensation (deficit)

Investors tend to stay away from debt securities in markets with high interest rates and a risk of ____________

high/very high inflation - can more than offset high interest payments

Aggregate Demand (AD)/ Aggregate Supply (AS)

households + businesses + federal gov't + municipal gov't + foreign

Net suppliers of funds

individuals/households

Aggregate supply curve is steep, meaning:

it is interest-inelastic.

Aggregate demand curve is less steep, meaning:

it is more elastic (than aggregate supply)

Reason for demanding loanable fund - business

long-term (fixed) and short-term assets (accounts receivable and inventory) Demand is inversely related to interest rate - because any demand for funds for this type of investment is positively related to the number of projects implemented

______ issue municipal bonds to obtain funds

municipal (state and local) governments

If the forecasted level of ND (Net Demand) is positive or negative:

then a disequilibrium will exist temporarily

Installment debt

Financed purchases of automobiles or household items (type of loan repaid with equal payments over a specific period of time)

supply of loanable funds

Households are largest supplier -More supply at higher rates -Supply by buying securities

Reason for demanding loanable fund - Households

Housing expenditures Automobiles & Household items (installment debt)

Net demanders of funds

businesses and governments