Two Major Causes of Interest RateDifferences

• I. Differences in interest rates over time due to changes in the macro economy, holding the intrinsic characteristics of the securities constant.

• II. Differences in interest rates intrinsic to the security, like term and risk, holding macroeconomic variables constant

• I. Macroeconomic Influences on Interest Rate

• Loanable funds framework (Bond’s market framework)

• Liquidity preference theory

The Loanable Funds theory

We use the term “loanable funds market” to describe the arrangements and institutions

by which saving of households is made available to borrowers.

Factor income

Consu

mpt

ion

1. Leakages must be recycled if total spending is to match full-employment GDP.

2. According to the Classical theory, the loanable funds market acts as a conduit to transfer spending power (S) from households to borrowing units (firms and government units).

3. Saving (S) is the “source” of loanable funds.

Saving

Net taxes

1. To have a more secure future, to start a business, to finance a child’s education, to satisfy miserliness, . . .

2. To earn interest. We view interest as

the “reward for saving” or the “reward for postponing

gratification.”

Interest rate Future value4% $1,127.275% $1,161.476% $1,196.687% $1,232.938% $1,270.249% $1,308.6510% $1,348.1811% $1,388.8812% $1,430.77

Value of $1,000 in 3 years at alternative interest rates

The opportunity cost of spending now (measured in lost

future spending) is positively related to

the interest rate.

Saving = Supply of Funds

Trillions of Dollars

0

Inte

rest

rat

e

3%

5%

1.5 1.75

Supply of Funds

•To finance the acquisition of long-lived capital goods.

•The rate of interest is the cost of borrowing or the price of loanable funds.

•The investment demand curve indicates the level of investment spending at various interest rates.

•As the interest rate decreases, more investment projects become attractive in the assessment of business decision-makers—hence, the investment demand function is downward-sloping with respect to the interest rate.

Investment Demand

Trillions of Dollars

0

Inte

rest

rat

e

3%

5%

1.5

Demand for Funds by Business

1.0

A

B

When the interest rate falls, investment spending and the business borrowing needed to finance it rises.

Public sector borrowing

•Let G denote public sector (or government) spending for goods and services in a year

•T is net tax receipts in a year.

•If G is greater than T, the the public sector has a budget deficit equal to G – T.

•If T is greater than G, then the public sector has a surplus equal to T – G.

•If the public sector has a budget deficit, it must borrow.

Public Sector Borrowing in Classica

G = $2 trillionT = $1.25 trillionTherefore, Budget Deficit = G – T = $2 trillion - $1.25 trillion = $0.75 trillion

0.750

5%

3%

Government Demand for Funds

I nt e

rest

Ra t

e

Trillions of Dollars

A

B

[1] [2] [3] = [1] + [2]

Interest Rate Business Demand Government Demand Total Demand

5% 1.0 0.75 1.753% 1.5 0.75 2.25

Demand for Loanable Funds (in Trillions)

Inte

rest

Rat

e

Trillions of Dollars0

3%

5%

1.75 2.25

Total Demand for Funds

Inte

rest

Rat

e

Trillions of Dollars

Loanable Funds Market Equilibrium

Total Supply of Funds (Saving)

Total Demand for Funds (Investment + Deficit)

E5%

0 1.75

So long as the loanable funds market “clears,” leakages (Saving) will be offset to

injections (investment and government spending).

Firms

Government

Households

Resource Markets

GoodsMarkets

Loanable Funds Markets

Income ($7 Trillion)

Factor Payments ($7 Trillion)

Government Spending ($2 Trillion)

Investment ($1 Trillion)

Consumption ($4 Trillion)

Firm Revenues ($7 Trillion)

Deficit ($0.75 Trillion

Income ($7 Trillion)

Saving ($1.75 Trillion)

Net Taxes ($1.25 Trillion)

Liquidity Preference Framework

• The concept was first developed by John Maynard Keynes in his book The General Theory of Employment, Interest and (1936)

• Liquidity preference theory answers the question that why interest should be paid?Explains determination of the interest rate by the supply and demand for money.

• Keynes defined interest as: “INTEREST IS THE REWARD TO SACRIFICE LIQUIDITY”

• When people lend their money their liquid assets decline, they must be paid for the liquidity the have forgone

• Liquidity Preference Theory: why do people hold money?

Medium of ExchangeUnit of AccountStore of Value

• If we assume that the income to be constant( short period indication ) then

Md= f (i)• Shows that there is a negative

relationship between money demand and interest rate.

• This relationship is given by liquidity Preference Curve as shown.

• Money Supply includes currency notes in circulation, demand deposits, creditmoney etc is set by the government ormonetary authority.

• Keynes assumed that the supply of money has nothing to do with the interest rate i.e. it remains constant.

Shifts in the demand formoney

• Income effect: a higher level of income causes the demand for money at eachinterest rate to increase and the demand curve to shift to the right.

• Price-level effect: a rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right.