The document discusses several theories of interest rate determination: 1. The classical theory argues that interest rates are determined by the supply of savings and demand for investment, where the equilibrium rate balances the two. 2. The liquidity preference theory views interest as the price of money, with rates set by demand for and supply of money in the economy. 3. The loanable funds theory sees rates as set by demand for and supply of credit in the economy from savers, borrowers, and foreign actors.

1. Chapter 6|INTEREST RATE DETERMINATION
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2. Nature of Interest Rates
 The very definition of interest depends on the interest theory
which one accepts. Those, who believe in the classical or real
theory, regard interest as payment for the use of capital goods.
 They also believe that interest is necessary to induce people to
save.
 Interest is “the price paid for the use of capital in any market”.
Just as wage is the price of the service of labor, similarly,
interest is the price of capital
 Interest thus “the market rate of interest is that percentage
return per year which has to be paid on any safe loan of money.

3. Cont’d
 The rate of interest (Cost of Capital) is the price paid by the
borrower for the use of others money over a period of time.
 Borrowers must pay interest to secure scarce loanable funds
from lender for an agreed-upon period.
 The rate of interest is really a ratio of two quantities:–
 the money cost of borrowing funds
 the amount of money actually borrowed
 Usually expressed on an annual percentage basis.

4. Cont’d
 Interest rates send price signals to borrowers, lenders, savers,
and investors.
 For example, higher interest rates generally bring forth a
greater volume of savings and stimulate the lending of funds.
 Lower interest rate, on the other hand, tend to lower the flow
of savings and reduce lending activity.
 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.

5. Functions of the Rate of Interest in the Economy
1. It helps to provide guarantee that current savings will flow into
investment to promote economic growth.
2. The rate of interest rations the available supply of credit,
generally providing loanable funds to investment projects with
the highest expected returns.
3. It brings into balance the nation’s supply of money with the
public’s demand for money.
4. The rate of interest is also an important tool of government
through its influence upon the volume of saving and
investment.

6. The Theory of Interest Rates
 There are several theories of interest rates and their
implications in the financial system. Among these theories,
the following four are the common as well as the popular
ones:
 The Classical theory of Interest Rates;
 Liquidity preference theory of interest rate;
 The Loanable Funds theory of Interest Rates;
 The Rational Expectations theory of Interest Rates.

7. The Classical Theory of Interest Rates
 The classical theory argues that rate of interest is determined by
two forces:
The supply of savings, derived mainly from households,
business org. and government unit.
The demand capital for investment by the business sector,
individuals and government units.
The classical economists believed that interest rates in the
financial market were determined by the interplay of the
supply of saving and the demand of capital for investment.

8. Cont’d
 The Classical Theory of Interest Rates argue that there is
positive relationship between interest rate and volume of
savings.
 Higher interest rates bring forth a greater volume of saving.
 On other hand classical theory states that there is a negative
relationship between demand of capital for investment and
interest rate.
 At low rates of interest more investment projects become
economically viable and firms require more funds to finance
projects.
 On the other hand, if the rate of interest rises to high levels,
fewer investment projects will be pursued and less funds will
be required.

9. Cont’d
Relationship between Interest Rates, Saving and
Investment
Interest
Rate
Current
Saving

r1
S1

r2
S2
Interest
Rate
Investment
Spending

r1
I1
I2

r2

10. Cont’d
 The Equilibrium Rate Of Interest is determined at the point
where the quantity of savings supplied to the market is exactly
equal to the quantity of funds demanded for investment.
 At the given time the rate is probably above or below its true
equilibrium level, the market rate of interest always moves
toward its equilibrium level.

11. The Equilibrium Rate of Interest
In the Classical Theory of Interest Rates
Interest
Rate
Savings &
Investment
rE
QE

Investment Savings
Cont’d

12. Cont’d
 If the market rate is temporarily above equilibrium, the
volume of savings Exceeds the demand for investment
capital, creating an excess supply of savings.
 Excess reserve forces Savers to offer their funds at lower
and lower rates until the market interest rate approaches
equilibrium.
 If the market rate lies temporarily below equilibrium,
investment demand exceeds the quantity of savings
available.
 Business firms increase the interest rate until it approaches
equilibrium point.

13. Limitations of the Classical Theory of Interest
 The central problem is that the theory ignores several
factors other than saving and investment which affect
interest rates.
 The classical theory assumes that interest rates are the
principal determinant of the quantity of savings available.
but, economists recognize that income is more important
than interest rates in determining the volume of saving.

14. The Liquidity Preference (cash balance) Theory
 Developed during the 1930s by British Economist John M.
Keynes.
 It is a short-run approach to interest rate determination because
it assumes that income remains stable.
 Keynes argued that the rate of interest is a payment for the use
of a scare resources- Money.
 Keynes also argue that even though money yield is low or
nonexistent, businesses and individuals Prefer to hold money
for carrying out daily transactions and future cash needs.

15.  Keynes observed that the public demands immediate money
for three different purposes.
 Transactions Motive: the demand for money in order to
purchase goods and services.
 Precautionary Motive: to cover future unexpected expenses,
because we live in a world of uncertainty and cannot predict
exactly what expenses or opportunities will arise in the
future.
 Speculative Motive: holding money to overcome uncertainty
about the declining security prices i.e. future price of Bonds.
Cont’d

16. Cont’d
The total demand for money in the economy is simply the sum
of transactions, precautionary, and speculative demands.
The other major element determining interest rates in liquidity
preference theory is the supply of money.
As money supply is controlled or at least closely regulated by
government it is inelastic with respect to the rate of interest.
For Keynes, the supply of money is fully under the control of
the central bank. Moreover, the money supply is not affected
by the level of the interest rate.

17. Cont’d
 In the theory of liquidity preference, only two outlets for investor
fund are considered or assumed- Bonds & Money (including bank
deposits).
 At a low interest rate, people hold a lot of money because they do
not lose much interest by doing so and because the risk of a rise
in rates (and a fall in the value of bonds) may be large.
 With a high interest rate, people desire to hold bonds rather than
money, because the cost of liquidity is substantial in terms of lost
interest payments and because a decline in the interest rate would
lead to gains in the bonds’ values.

18. Cont’d
 If we see the total money demand and total money supply; when
supply of money exceeds the quantity demanded and hence,
some businesses, households, and units of government will try to
dispose-off their unwanted money balances by purchasing
bonds. The prices of bonds will rise as a result, driving interest
rates down towards the equilibrium.
 On the other hand, at rates below equilibrium the quantity of
money demanded exceeds the supply. Some decision makers in
economy will sell their bonds to raise additional cash, driving
bond down and interest rates up toward equilibrium.

19. Limitation of liquidity preference theory
 It is a short-run approach to interest rate determination because it
assumes that income remains stable but in long run income is
not stable
 liquidity preference considers only the supply and demand for
the stock of money, whereas business, consumer, & government
demands for credit clearly have an impact upon the cost of credit
borrowers.

20. The Loanable Funds Theory
 Loanable funds is the sum total of all the money people and entities
in an economy have decided to save and lend out to borrowers as an
investment rather than use for personal consumption
 This view argues that the risk-free interest rate is determined by the
interplay of two forces:
 Demand for loanable funds and
 The supply of loanable funds.
 The demand for loanable funds consists of :
 Credit demands from domestic businesses;
 Consumers;
 Units of government and
 Borrowing in the domestic market by foreigners. Like Foreign
banks, corporations, and foreign governments

21. Cont’d
 The supply of loanable funds comes from people and organizations,
such as government and businesses, that have decided not to spend
some of their money, but instead, save it for investment purposes.
One way to make an investment is to lend money to borrowers at a
rate of interest.
 The supply of loanable funds stems from four sources:
 Domestic savings,
 Hoarding demand for money, either positive hoarding which
reduces volume of loanable funds or negative hoarding or
dishoarding, which increases volume of loanable funds,
 Money creation by the banking system, and
 Lending in the domestic market by foreign individuals &
institutions.

22.  The idea of rational expectations theory was first developed
1961 & popularized by economist Robert Lucas in the 1970s
The theory states the following assumptions:
 With rational expectations, people always learn from past
mistakes.
 Forecasts are unbiased, and people use all the available
information and economic theories to make decisions.
 In the rational expectations theory, individuals base their
decisions on human rationality, information available to them,
and their past experiences ……
The Rational Expectations Theory of Interest
Rates

23. Cont’d
 The rational expectations theory builds upon a growing body
of researches.
 Rational expectations theory developed on the bases that the
interest rate increase or decrease in the economy depends on
expectation of rational investors about future based on current
information.
 This theory evidence that the money and capital markets
which reacts to new information affects interest rates &
security prices.

24. Cont’d
 This theory states that , if the money & capital markets are
highly efficient interest rates will always be at or very near their
equilibrium levels.
 The rational expectations theory also suggests that interest rates
do not change permanently from their current equilibrium levels
unless new information appears.

25. The Structure of Interest Rates
 There is no one interest rate in any economy; rather, there is a
structure of interest rates.
 The term structure of interest rates refers to the relationship
between interest rates or bond yields and different terms or
maturities.
The Base of Interest Rate:
 Market participants throughout the world view Treasury bill as
having no credit risk.
 As a result, the interest rates on Treasury securities have served
as the benchmark interest or basis of interest rate throughout
international financial market.

26. Cont’d
Interest Rate = Base Interest Rate + Risk Premium
 A risk premium reflects the additional risks the investor faces by
acquiring non-treasury bill securities.
 The factors that affect risk premium of securities are:
1. The issuer’s perceived creditworthiness
 Default risk or credit risk refers to the risk that the issuer of a bond may
be unable to make timely principal or interest payments
 Most market participants rely primarily on commercial rating companies
(credit rating companies) to assess the default risk of an issuer.
2. Term of maturity
3. Taxability of interest

27. Factors affecting interest rate determination
 Demand for and supply of money
 Government borrowing
 Inflation
 Central Bank's monetary policy objectives etc.

28. THE END