Fin 310 Chapter 2

Jayhawk Forecasting Services analyzed several factors that could affect interest rates in the future. Most factors were expected to place downward pressure on interest rates. Jayhawk also expected that although the annual budget deficit was to be cut by 40 percent from the previous year, it would still be very large. Thus, Jayhawk believed that the deficit's impact would more than offset the effects of other factors, so it forecast interest rates to increase by 2 percent. Comment on Jayhawk's logic.

A reduction in the deficit should free up some funds that had been used to support the government borrowings. Thus, there should be additional funds available to satisfy other borrowing needs. Given this situation plus the other information, Jayhawk should have forecasted lower interest rates.

During the credit crisis, U.S. interest rates were extremely low, which enabled businesses to borrow at a low cost. Holding other factors constant, this should result in a higher number of feasible projects, which should encourage businesses to borrow more money and expand. Yet, many businesses that had access to loanable funds were unwilling to borrow during the credit crisis. What other factor changed during this period that more than offset the potentially favorable effect of the low interest rates on project feasibility, therefore discouraging businesses from expanding?

Businesses recognized that the cash flows to be generated from their projects would be low because the demand for their products and services was limited. Households could not afford to purchase more products. Thus, while low interest rates allow businesses to borrow funds cheap, many possible projects were not feasible because the expected cash flows were not sufficient.

Explain why interest rates tend to decrease during recessionary periods. Review historical interest rates to determine how they react to recessionary periods. Explain this reaction.

During a recession, firms and consumers reduce their amount of borrowing. The demand for loanable funds decreases and interest rates decrease as a result.

interest inelastic

Insensitive to interest rates

foreign demand

depends on interest rate differential between the two countries

crowding out effect

government demand for funds crowd out private demand for funds

economic conditions

primary forces in change in supply of savings

loanable funds theory

theory used to explain interest rate movements, suggests that the market interest rate is determined by the factors controlling the supply of and demand for loanable funds.

What is the difference between the nominal interest rate and real interest rate? What is the logic behind the implied positive relationship between expected inflation and nominal interest rates?

The nominal interest rate is the quoted interest rate, while the real interest rate is defined as the nominal interest rate minus the expected rate of inflation. The real interest rate represents the recent nominal interest rate minus the recent inflation rate. Investors require a positive real return, which suggests that they will only invest funds if the nominal interest rate is expected to exceed inflation. In this way, the purchasing power of invested funds increases over time. As inflation rises, nominal interest rates should rise as well since investors would require a nominal return that exceeds the inflation rate.

Should increasing money supply growth place upward or downward pressure on interest rates?

If one believes that higher money supply growth will not cause inflationary expectations, the additional supply of funds places downward pressure on interest rates. However, if one believes that inflation expectations do erupt as a result, demand for loanable funds will also increase, and interest rates could increase (if the increase in demand more than offsets the increase in supply).

Explain what is meant by interest elasticity. Would you expect federal government demand for loanable funds to be more or less interest-elastic than household demand for loanable funds? Why?

Interest elasticity of supply represents a change in the quantity of loanable funds supplied in response to a change in interest rates. Interest elasticity of demand represents a change in the quantity of loanable funds demanded in response to a change in interest rates.

factors that affect interest rate movement

economic growth, inflation, budget deficit, foreign interest rates, and money supply.