FINANCIAL INSTITUTIONS & CH03: INTEREST RATES IN THE FINANCIAL

MARKETS SYSTEM

CHAPTER 3
INTEREST RATES IN THE FINANCIAL SYSTEM
INTRODUCTION
 The acts of saving and lending, borrowing and investing are intimately (closely) linked
through the entire financial system.
 And one factor that significantly influences and ties all of them together is the rate of
interest.
 The rate of interest is the price a borrower must pay to secure scarce loan able funds from
a lender for an agreed-upon time period. But unlike other prices in the economy, the rate
of interest is really a ratio of two quantities: the money cost of borrowing divided by
the amount of money actually borrowed, usually expressed on an annual percentage
basis.
 Interest rates send price signals to those who ultimately supply funds to the economy
through saving and lending and to those who ultimately demand funds by borrowing to
make capital investments in the economy.
 Higher interest rates provide incentives to increase the supply of funds, but at the same
time they reduce the demand for those funds.
 Lower interest rates have the opposite effects. Since the total amount of funds supplied
by the financial system must just equal the total amount borrowed-that is, quantity
supplied equals quantity demanded, then whether an increase in interest rates increases
the total amount of funds available in the economy depends on whether the supply
response of savers and lenders is greater or less than the demand response of borrowers.

3.1. The Theory and structure of Interest Rates

1. Classical Theory of interest Rates

The classical theory argues that the rate of interest is determined by two forces:
1. The supply of savings , derived mainly from households, and
2. The demand for investment capital, coming mainly from the business sector.
 Saving by Households
 The classical theory of interest assumes that individuals have a definite time preference
for current over future consumption.
 A rational individual, it is assumed, will always prefer current enjoyment of goods and
services over future enjoyment.
 Therefore, the only way to encourage an individual or family to consume less now and
save more is to offer a higher rate of interest on current savings.
 If more were saved in the current period at a higher rate of return, future consumption
would be increased.
FINANCIAL INSTITUTIONS & CH03: INTEREST RATES IN THE FINANCIAL
MARKETS SYSTEM

 The classical theory considers the payment of interest a reward for waiting-the
postponement of current consumption in favor of greater future consumption.

 Higher interest rates increase the attractiveness of saving relative to consumption

spending, encouraging more individuals to substitute current saving (and future
consumption) for some quantity of current consumption.

 This so-called substitution effect calls for a positive relationship between interest rates
and the volume of savings.

 Higher interest rates bring forth a greater volume of current savings.

 Saving by Business Firms
 Not only households but also businesses save.
 Most businesses hold savings balances in the form of retained earnings (as reflected in
their equity or net worth accounts).
 In fact, the increase in retained earnings reported by businesses each year is a key
measure of the volume of current business saving, which supplies most of the money for
annual investment spending by business firms.
 The critical element in determining the amount of business savings is the level of
business profits.
 If profits are expected to rise, businesses will be able to draw more heavily on earnings
retained in the firm and less heavily on the money capital markets for funds.
 The result is a reduction in the demand for credit and a tendency toward lower interest
rates.
 On the other hand, when profits fall but firms do not cut back on their investment plans,
they will be forced to make the heavier use of the money and capital markets for
investment funds.
 The demand for credit rises, and interest rates may rise as well.
 Although the principal determinant of business saving is profits, interest rates also play a
role in the decision of what proportion of current operating costs and long-term
investment expenditures should be financed internally from retained earnings and what
proportion should be financed externally from borrowing in the money and capital
markets.
 Higher interest rates in the money and capital markets typically encourage firms to use
internally generated funds more heavily in financing their projects.
 Conversely (in the other hand), lower interest rates encourage greater use of external
funds from the money and capital markets.
 Saving by Government
 Governments also save, though usually less frequently than households and businesses.
 In fact, most government saving (i.e., a budget surplus) appears to be unintended
(unplanned) saving that arises when government receipts unexpectedly exceed the actual
amount of expenditures.
 Income flows in the economy (out of which government tax revenues arise) and the
pacing of government spending programs are the dominant factors affecting government
savings.
FINANCIAL INSTITUTIONS & CH03: INTEREST RATES IN THE FINANCIAL
MARKETS SYSTEM

 However, interest rates can play a role in that higher interest rates raise interest payments
owed on the government’s debt. These higher expenditures tend to increase government
deficits (reduce budget surpluses), and, thereby, reduce government savings.
 The Demand for Investment Funds
Business, household, and government savings are important determinants of interest rates
according to the classical theory of interest, but they are not the only ones. The other critical rate-
determining factor is investment spending, most of it carried out by business firms.

Certainly, businesses, as the leading investment sector in the economy, require huge amount of
funds each year to purchase equipment, machinery, and inventories, and to support the
construction of new buildings and other physical facilities. The majority of business expenditure
for these purposes consists of replacement investment; that is, expenditures to replace equipment
and facilities that are wearing out or are technologically obsolete.
A smaller but more dynamic form of business capital spending is labeled net investment:
expenditures to acquire new equipment and facilities in order to increase output. The sum of
replacement investment plus net investment equals gross investment.

Limitations of the Classical Theory of Interest

The classical theory of interest sheds (get rid of) light on the factors affecting interest rates.
However, it has limitations. The central problem is that the theory ignores factors other than
saving and investment that affect interest rates. For example, many financial institutions have the
power to create money today by making loans to the public. When borrowers repay their loans,
money is destroyed. The volume of money created or destroyed affects the total amount of credit
available in the financial system and, therefore; must be considered in any explanation of interest
rates. In addition, the classical theory assumes that interest rates are the principal determinant of
the quantity of savings available. Today economists recognize that income and wealth are
probably more important in determining the volume of saving. Finally, the classical theory
contends (run) that the demand for borrowed funds comes principally from the business sector.
Today, however; both consumers and government are also important borrowers.

2. The Liquidity Preference or Cash Balances Theory of Interest Rates

 The Demand for Liquidity

The liquidity preference theory contends that the rate of interest is really a payment for the use of
a scarce resource-money (cash balances). Businesses and individuals prefer to hold money for
carrying out daily transactions and also as a precaution against future cash needs even though
money’s yield is usually low or even nonexistent. Investors in fixed-income securities, such as
government bonds, frequently desire to hold money or cash balances as a haven against declining
asset prices. Interest rates, therefore; are the price that must be paid to induce money holders to
surrender a perfectly liquid asset (cash balances) and hold other assets that carry more risk. At
times the preference for liquidity grows very strong. Unless the money supply is expanded,
interest rates will rise.
FINANCIAL INSTITUTIONS & CH03: INTEREST RATES IN THE FINANCIAL
MARKETS SYSTEM

In the theory of liquidity preference, only two outlets for investor funds are considered: bonds
and money or cash balances (including bank deposits). Money provides perfect liquidity (instant
spending power). Bonds pay interest but cannot be spent until converted into cash. If interest
rates raise, the market value of bonds paying a fixed rate of interest falls; the investor would
suffer a capital if those bonds were converted into cash. On the other hand, a fall in interest rates
results in higher bond prices; the bondholder will experience a capital gain if his/her bonds are
sold for cash. To the classical theorists, it was irrational to hold money because it provided little
or no return. To proponents of liquidity preference, however; the holding of money (cash
balances) could be a perfectly rational act if interest rates were expected to rise, because rising
rates can result in substantial losses for investors in bonds.
 Motives for Holding Money (Cash Balances)
According to liquidity preference theory, the public demands money for three different purposes
(motives).
i. Transaction motive: represents the demand for money (cash balances) to
purchase goods and services. Because inflows and outflows of money are not
perfectly synchronized in either timing or amount and because it is costly to shift
back and forth between money and other assets, businesses, households, and
governments must keep some cash in the till or in demand accounts simply to
meet daily expenses.
ii. Precautionary motive: Some money also must be held as a reserve for future
emergencies and to cover extraordinary expenses. This precautionary motive
arises because we live in a world of uncertainty and cannot predict exactly what
expenses or investment opportunities will arise in the future.
iii. Speculative motive: this stems from uncertainty about the future prices of bonds.
If investors expect rising interest rates, many of them will demand money or near
–money assets (such as deposits in a bank, credit union, or money market fund)
instead of bonds because they believe bond prices will fall. As the expectation
that interest rates will rise grows strong in the market place, the demand for cash
balances as a secure store of value increases.
 Total Demand for Money (Cash Balances)
The total demand for money or cash balances in the economy is simply the sum of transactions,
precautionary, and speculative demands. Because the principal determinant of transactions and
precautionary demand is income, not interest rates, these money demands are fixed at a certain
level of national income.
 The Supply of Money (Cash Balances)
The other major element determining interest rates in liquidity preference theory is the supply of
money. In modern economies, the money supply is controlled, or at least closely regulated, by
government. Because government decisions concerning the size of the money supply presumably
are guided by the public welfare, not by the level of interest rates, we assume that the supply of
cash balances is inelastic with respect to the rate of interest.
FINANCIAL INSTITUTIONS & CH03: INTEREST RATES IN THE FINANCIAL
MARKETS SYSTEM

Limitations of the Liquidity Preference Theory

It is a short-term approach to interest rate determination unless modified because it assumes that
income remains stable. In the longer term, interest rates are affected by changes in the level of
income and by inflationary expectations. Indeed, it is impossible to have a stable equilibrium
interest rate without also reaching an equilibrium level of income, saving, and investment in the
economy. Also, liquidity preference considers only the supply and demand for the stock of
money, whereas business, consumer, and government demands for credit clearly have an impact
on the cost of credit. A more comprehensive view of interest rates is needed that considers the
important roles played by all actors in the financial system: businesses, households, and
governments.

3. The Loanable Funds Theory of Interest

A view that overcomes many of the limitations of earlier theories is the loanable funds theory of
interest rate. It is the most popular interest rate theory among practitioners and those who follow
interest rates “on the street.” The loanable funds view argues that the risk-free interest rate is
determined by the interplay of two forces: the demand for and supply of credit (loanable funds).
The demand for loanable funds consists of credit demands from domestic businesses, consumers,
and governments, and also borrowing in the domestic market by foreigners. The supply of
loanable funds stems from domestic savings, dishoarding of money balances, money creation by
the banking system, and lending in the domestic market by foreign individuals and institutions.
NOTE THAT: According to this theory:
 Total demand for loanable funds = DD by consumers + DD by business + DD by
government + DD by foreign (where; DD = Demand)

 Total supply of loanable funds = Domestic savings + newly created money +

Foreign lending to domestic credit markets – Hoarding DD for cash balances. ….
(DD = Demand)
4. The Rational Expectations Theory of Interest
This theory builds on a growing body of research evidence that the money and capital markets
are highly efficient institutions in digesting new information affecting interest rates and security
prices. For example, when new information appears about investment, saving or the money
supply, investors begin immediately to translate that new information into decisions to borrow or
lend funds. So rapid is this process of the market digesting new information that asset prices and
interest rates presumably incorporate the new data from virtually the moment they appear. In a
perfectly efficient market, it is impossible to win excess returns consistently by trading on
publicly available information.

This expectation theory assumes that businesses and individuals are rational agents who attempt
to make optimal use of the resources at their disposal in order to maximize their returns.
Moreover, a rational agent will tend to make unbiased forecasts of future asset prices, interest
rates, and other variables. That is, he or she will make no systematic forecasting errors and will
easily spot past patterns in forecast errors and correct them quickly.
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MARKETS SYSTEM

If the money and capital markets are highly efficient, this implies that interest rates always be
very near their equilibrium levels. Any deviation from the equilibrium interest rate dictated by
demand and supply forces will almost instantly eliminated. Security traders who hope to
consistently earn windfall profits from correctly guessing whether interest rates are ‘’too high’’
(and therefore will probably fall) or “too low” (and therefore will probably rise) are unlikely to
be successful in the long term. Interest rate fluctuations around equilibrium are likely to be
random and rapid.
Moreover, knowledge of past interest rates-for example, those that prevailed yesterday or
last month – will not be a reliable forecast of where those rates are likely to be in the future.
Indeed, the rational expectation theory suggests that, in the absence of new information, the
optimal forecast of next period’s interest rate would probably be equal to the current
period’s interest rate because there is no particular reason for the next period’s interest rate
to be either higher or lower than today’s interest rate until new information causes market
participants to revise their expectations.

Old news will not affect today’s interest rates because those rates already have impounded
the old news. Interest rates will change only if entirely new and unexpected information
appears. For example, if the federal government announces for several weeks running that it
must borrow an additional $10 billion next month, interest rates probably reacted to that
information the first time it appeared. In fact, interest rates probably increased at that time,
because many investors would view the government’s additional need for credit as adding to
other demands for credit in the economy and, with the supply of funds unchanged, interest
rates would be expected to rise. However, if the government merely repeated that same
announcement again, interest rates probably would not change a second time, it would be
old information already reflected in today’s interest rates.

3.2. Factors affecting structure of interest rate determinations

The term structure of interest rates is the relationship between interest rates or bond yields
and different terms or maturities. The term structure of interest rates is also known as a yield
curve and it plays a central role in an economy. The term structure reflects expectations of
market participants about future changes in interest rates and their assessment of monetary
policy conditions. There are 3 factors that affect the structure of interest rate determination.
Those are:

1. Default risk: One attribute of bond that influences its interest rates is default risk. It
occurs when the issuer of bond is unable or unwilling to make interest payments
when promised or pay off the face value when the bond is mature. The spread
between the interest rate on one bond with default risk and default free bond with the
same maturity is called risk premium. A bond with default risk will always have
positive risk premium and increases its risk premium with increase of bond default.
FINANCIAL INSTITUTIONS & CH03: INTEREST RATES IN THE FINANCIAL
MARKETS SYSTEM

2. Liquidity: Another factor that affects the interest rates is its liquidity. The bonds with
guaranty of more liquidity will be more desirable by the public. Because, early
conversion is safe of cash but, less of interest rates; more desirable will have demand
which in turn leads to less rate of interest. For instance, government bonds like
treasury bond (TB) are more liquid and have less interest rate (Because of conversion
requires less time, low transaction cost and it is tax-free). The reverse is true for
corporation bonds.
3. Income tax: Tax imposed also count the calculation of interest rates of a bond.
Example: municipality bonds are default free risk and tax free. But, they are with less
interest rate. On the other hand, corporation bonds are with high interest rate. But
public prefer to invest in municipality bonds as they are tax-free.

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