BFMS L02 Theory And Structure Of Interest Rates
Banking, Financial Markets and Systems
Set - 2
Theory and Structure of Interest rates
P C Narayan
IIMB PCN BFMS L02
1
Loanable Funds theory
“Market interest Rate is determined by the factors that control the supply and demand for loanable funds”
IIMB PCN BFMS L02
2
1
Demand for Loanable Funds
• Household demand for loanable funds
– As household income rises, so does installment debt
– Inverse relationship between demand for lonable funds and interest rate
• Business demand for loanable funds
– Inverse relationship between demand for lonable funds and interest rate
• Government demand for loanable funds
– Interest inelastic since borrowing to meet deficit
• Foreign demand for loanable funds
– Country A issues securities to investors of country B
• Total Demand for lonable funds Da =
Dh + Db + Dg + Df
IIMB PCN BFMS L02
3
Supply of Loanable Funds
• Household sector is the largest followed by
Government and Business (Sa)
• Directly proportional to interest rates
_______________________________________
In equilibrium, Da = Sa
• And the interest rate at this point is is known as
‘equilibrium interest rate’
• Change in demand or supply causes a change in
‘equilibrium interest rate’
IIMB PCN BFMS L02
4
2
Fisher Effect
• Offers an additional explanation to the loanable funds theory
• Nominal Interest rate
– Compensates for reduced purchasing power
– Provides a premium for foregoing present consumption
• (1+In ) = (1+ir)*(1+E(i))
• Which can be simplified as
In = ir + E(i)
where in is the Nominal interest rate
ir is the Real interest rate
E(i) is the Expected inflation
• Since ir cannot be negative, higher inflation tends to push up interest rates
IIMB PCN BFMS L02
5
Key issues impacting Interest rates
• Impact of Inflation
• Impact of budget deficit
• Impact of foreign interest rates
IIMB PCN BFMS L02
6
3
Term Structure of Interest rates
• Relationship between term to maturity and annualised yield
• ‘Pure Expectations’ theory
• ‘Liquidity
Set - 2
Theory and Structure of Interest rates
P C Narayan
IIMB PCN BFMS L02
1
Loanable Funds theory
“Market interest Rate is determined by the factors that control the supply and demand for loanable funds”
IIMB PCN BFMS L02
2
1
Demand for Loanable Funds
• Household demand for loanable funds
– As household income rises, so does installment debt
– Inverse relationship between demand for lonable funds and interest rate
• Business demand for loanable funds
– Inverse relationship between demand for lonable funds and interest rate
• Government demand for loanable funds
– Interest inelastic since borrowing to meet deficit
• Foreign demand for loanable funds
– Country A issues securities to investors of country B
• Total Demand for lonable funds Da =
Dh + Db + Dg + Df
IIMB PCN BFMS L02
3
Supply of Loanable Funds
• Household sector is the largest followed by
Government and Business (Sa)
• Directly proportional to interest rates
_______________________________________
In equilibrium, Da = Sa
• And the interest rate at this point is is known as
‘equilibrium interest rate’
• Change in demand or supply causes a change in
‘equilibrium interest rate’
IIMB PCN BFMS L02
4
2
Fisher Effect
• Offers an additional explanation to the loanable funds theory
• Nominal Interest rate
– Compensates for reduced purchasing power
– Provides a premium for foregoing present consumption
• (1+In ) = (1+ir)*(1+E(i))
• Which can be simplified as
In = ir + E(i)
where in is the Nominal interest rate
ir is the Real interest rate
E(i) is the Expected inflation
• Since ir cannot be negative, higher inflation tends to push up interest rates
IIMB PCN BFMS L02
5
Key issues impacting Interest rates
• Impact of Inflation
• Impact of budget deficit
• Impact of foreign interest rates
IIMB PCN BFMS L02
6
3
Term Structure of Interest rates
• Relationship between term to maturity and annualised yield
• ‘Pure Expectations’ theory
• ‘Liquidity