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Understanding Interest Rate Determination: Loanable Funds Theory and Fisher Effect

This chapter delves into the determination of interest rates through the lens of loanable funds theory and liquidity preference. It explores the concepts of equilibrium in the financial market, the interaction of bond demand and supply, and the dynamics of market yields over time. Key applications such as the Fisher Effect, which highlights the relationship between nominal interest rates and inflation expectations, are examined. Additionally, the impact of monetary policy on interest rates across business cycles is discussed, providing a comprehensive overview of factors influencing interest rate levels.

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Understanding Interest Rate Determination: Loanable Funds Theory and Fisher Effect

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  1. Chapter 6:Learning Objectives • Interest Rate Level Determination:

  2. Chapter 6:Learning Objectives • Interest Rate Level Determination: • Loanable funds vs. Liquidity preference

  3. Chapter 6:Learning Objectives • Interest Rate Level Determination: • Loanable funds vs. Liquidity preference • Equilibrium Determination & Changes

  4. Chapter 6:Learning Objectives • Interest Rate Level Determination: • Loanable funds vs. Liquidity preference • Equilibrium Determination & Changes • Applications:

  5. Chapter 6:Learning Objectives • Interest Rate Level Determination: • Loanable funds vs. Liquidity preference • Equilibrium Determination & Changes • Applications: • Fisher effect

  6. Chapter 6:Learning Objectives • Interest Rate Level Determination: • Loanable funds vs. Liquidity preference • Equilibrium Determination & Changes • Applications: • Fisher effect • interest rates over the business cycle

  7. Chapter 6:Learning Objectives • Interest Rate Level Determination: • Loanable funds vs. Liquidity preference • Equilibrium Determination & Changes • Applications: • Fisher effect • interest rates over the business cycle • the impact of a tight monetary policy

  8. A Selection of Yields over Time

  9. Loanable Funds Theory • Focus is on the Market for bonds

  10. Loanable Funds Theory • Focus is on the Market for bonds • Bond demand (Bd) is determined by investors’ preferences

  11. Loanable Funds Theory • Focus is on the Market for bonds • Bond demand (Bd) is determined by investors’ preferences • Bond supply (Bs) is determined by borrowers’ preferences

  12. Loanable Funds Theory • Focus is on the Market for bonds • Bond demand (Bd) is determined by investors’ preferences • Bond supply (Bs) is determined by borrowers’ preferences • For discussion purposes, ASSUME a one-year discount bond •  $PD is inversely related to R (=[$FV-$PD]/$PD

  13. Loanable Funds Theory • Focus is on the Market for bonds • Bond demand (Bd) is determined by investors’ preferences • Bond supply (Bs) is determined by borrowers’ preferences • For discussion purposes, ASSUME a one-year discount bond •  $PD is inversely related to R (=[$FV-$PD]/$PD) • The interaction between Bond demand and supply determines the equilibrium interest rate

  14. From Bond demand/supply to Loanable funds demand/supply BOND DEMAND=SUPPLY OF LOANABLE FUNDS

  15. From Bond demand/supply to Loanable funds demand/supply BOND DEMAND=SUPPLY OF LOANABLE FUNDS BOND SUPPLY=DEMAND FOR LOANABLE FUNDS

  16. Figure 6.4. Market Equilibrium LFs Excess supply C D R1 • • Nominal interest rate R* • E R0 • • A B Excess demand LFd B* Quantity of bonds

  17. DEMAND SIDE INFLUENCES Wealth (+ve) SUPPLY SIDE INFLUENCES Shifts in Loanable Funds demand/supply

  18. DEMAND SIDE INFLUENCES Wealth (+ve) Relative returns (+ve) SUPPLY SIDE INFLUENCES Shifts in Loanable Funds demand/supply

  19. DEMAND SIDE INFLUENCES Wealth (+ve) Relative returns (+ve) Relative riskiness (-ve) SUPPLY SIDE INFLUENCES Shifts in Loanable Funds demand/supply

  20. DEMAND SIDE INFLUENCES Wealth (+ve) Relative returns (+ve) Relative riskiness (-ve) Liquidity (+ve) SUPPLY SIDE INFLUENCES Shifts in Loanable Funds demand/supply

  21. DEMAND SIDE INFLUENCES Wealth (+ve) Relative returns (+ve) Relative riskiness (-ve) Liquidity (+ve) Expected inflation (-ve) SUPPLY SIDE INFLUENCES Shifts in Loanable Funds demand/supply

  22. Expected returns (+ve) DEMAND SIDE INFLUENCES Wealth (+ve) Relative returns (+ve) Relative riskiness (-ve) Liquidity (+ve) Expected inflation (-ve) SUPPLY SIDE INFLUENCES Shifts in Loanable Funds demand/supply

  23. Expected returns (+ve) Govt policies (?) DEMAND SIDE INFLUENCES Wealth (+ve) Relative returns (+ve) Relative riskiness (-ve) Liquidity (+ve) Expected inflation (-ve) SUPPLY SIDE INFLUENCES Shifts in Loanable Funds demand/supply

  24. Expected returns (+ve) Govt policies (?) Expected Inflation (+ve) DEMAND SIDE INFLUENCES Wealth (+ve) Relative returns (+ve) Relative riskiness (-ve) Liquidity (+ve) Expected inflation (-ve) SUPPLY SIDE INFLUENCES Shifts in Loanable Funds demand/supply

  25. A R1 • • Nominal interest rate R2 • B LFd1 LFd2 B2 B1 Quantity of bonds Figure 6.5. Shifts in the Demand for and Supply of Loanable Funds A. A Demand Shift

  26. LFs2 LFs1 R1 Nominal interest rate • • B2 B1 Quantity of bonds Figure 6.5. Shifts in the Demand for and Supply of Loanable Funds B. A Supply Shift

  27. Two Applications • The Fisher Effect: how inflation expectations affect nominal interest rates  distinction between nominal and real interest rates (Recall: R=+e)Figure 6.6

  28. Two Applications • The Fisher Effect: how inflation expectations affect nominal interest rates  distinction between nominal and real interest rates (Recall: R=+e)Figure 6.6 • The business cycle and interest rates: how changes in economic activity affect nominal interest ratesFigure 6.8

  29. LFs1 LFs0 R*1=*0+ 1e E’ • Nominal interest rate R*0= *0 +e0 • E LFd0 LFd1 B* Quantity of bonds Figure 6.6. The Fisher Effect

  30. LFs0 LFs1 R*1 • E’ Nominal interest rate R*0 • E LFd1 LFd0 B0 B1 Quantity of bonds Figure 6.8. Interest Rates in an Expansion

  31. The Nominal Interest Rate and Economic Growth

  32. Economics Focus 6.2: Measuring Real GDP

  33. Economics Focus 6.2: Measuring Real GDP [Cont’d]

  34. Liquidity Preference Theory • Focus is on the role of monetary policy

  35. Liquidity Preference Theory • Focus is on the role of monetary policy • Demand for money (Md) is determined by the preferences of holders of money ( M1)

  36. Liquidity Preference Theory • Focus is on the role of monetary policy • Demand for money (Md) is determined by the preferences of holders of money ( M1) • Supply of Money is determined by the central bank and the financial sector

  37. Liquidity Preference Theory • Focus is on the role of monetary policy • Demand for money (Md) is determined by the preferences of holders of money ( M1) • Supply of Money is determined by the central bank and the financial sector • The interaction of money demand/supply produces an equilibrium interest rate

  38. Why Hold Money? • TRANSACTIONS MOTIVE: used in the buying and selling of goods and services

  39. Why Hold Money? • TRANSACTIONS MOTIVE: used in the buying and selling of goods and services • PRECAUTIONARY MOTIVE: used as a “buffer” against unexpected events

  40. Why Hold Money? • TRANSACTIONS MOTIVE: used in the buying and selling of goods and services • PRECAUTIONARY MOTIVE: used as a “buffer” against unexpected events • SPECULATIVE MOTIVE: represents one asset in a “portfolio” of assets

  41. Analysis of Monetary Policy Static Analysis Dynamic Analysis Money Supply Money Supply g=0 Ms1 g=0 g><0 g=0 MS0 Time Time  = {[MSt - MSt-1]/MSt-1} X 100

  42. Ms1 Ms0 Nominal interest rate R*1 • R*0 • E Md0 M*1 M*0 Quantity of money Figure 6.10. Contractionary Monetary Policy

  43. Money Growth and Interest Rates

  44. The (Dynamic) Link Between Money Growth and the Interest Rate  1 0 2 Time R R1 R2 R0 Time

  45. The Liquidity Trap • When nominal interest rates are close to zero can monetary policy be effective

  46. The Liquidity Trap • When nominal interest rates are close to zero can monetary policy be effective? • It has been suggested that monetary policy is then like pushing on a string

  47. The Liquidity Trap • When nominal interest rates are close to zero can monetary policy be effective? • It has been suggested that monetary policy is then like pushing on a string • But, monetary policy is more than just changing the money supply or even changing interest rates. Its about changing expectations of future inflation. The trap can, in principle, be avoided

  48. Summary • There are 2 theories of interest rate determination: the loanable funds and liquidity preference models

  49. Summary • There are 2 theories of interest rate determination: the loanable funds and liquidity preference models • Loanable funds focuses on the bond market

  50. Summary • There are 2 theories of interest rate determination: the loanable funds and liquidity preference models • Loanable funds focuses on the bond market • Liquidity preference focuses on the demand for money and the role of monetary policy

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