Tài chính doanh nghiệp - Chapter 5: The determinants of interest rates: Competing ideas

Chapter 5The Determinants of Interest Rates: Competing Ideas Learning Objectives To understand the important roles that interest rates play within the economy.To explore the most important ideas about what determines the level of interest rates and asset prices within the financial system.To identify the key forces that economists believe set market interest rates and asset prices into motion.IntroductionThe acts of saving and lending, and borrowing and investing, are significantly influenced by and tied together by the interest rate.The interest rate is the price a borrower must pay to secure scarce loanable funds from a lender for an agreed-upon time period. IntroductionSome authorities refer to the rate of interest as the price of credit.Interest rates send price signals to borrowers, lender, savers, and investors. Whether higher interest rates increase or decrease savings and investment depends on the relative strength of its effect on supply and demand factors.Functions of the Interest Rate in the EconomyThe interest rate helps guarantee that current savings will flow into investment to promote economic growth.It allocates the available supply of credit, generally providing loanable funds to those investment projects with the highest expected returns.It brings the supply of money into balance with the public’s demand for money.Functions of the Interest Rate in the EconomyThe interest rate serves as an important tool for government policy through its influence on the volume of savings and investment.Functions of the Interest Rate in the EconomyTo help uncover these rate-determining forces, we assume that there is one fundamental interest rate, known as the pure or risk-free rate of interest, which is a component of all interest rates.The closest real-world approximation to this pure rate of return is the market interest rate on government bonds.The Classical Theory of Interest RatesThe classical theory argues that the rate of interest is determined by two forces:the supply of savings, derived mainly from households, andthe demand for investment capital, coming mainly from the business sector.The Classical Theory of Interest RatesHousehold SavingsCurrent household savings equal the difference between current income and current consumption expenditures.Individuals prefer current over future consumption, and the payment of interest is a reward for waiting.Higher interest rates encourage the substitution of current saving for current consumption.The Classical Theory of Interest RatesThe Substitution EffectRelating Savings and Interest RatesInterestRateCurrentSavingr1S1r2S2The Classical Theory of Interest RatesBusiness and Government SavingsMost businesses hold savings balances in the form of retained earnings, the amount of which is determined principally by business profits, and to a lesser extent, by interest rates.Income flows in the economy and the pacing of government spending programs are the dominant factors affecting government savings (budget surplus).The Classical Theory of Interest RatesThe Demand for Investment FundsGross business investment equals the sum of replacement investment and net investment.One investment decision-making method involves the calculation of a project’s expected internal rate of return, and the comparison of that expected return with the anticipated returns of alternative projects, as well as with market interest rates.The Classical Theory of Interest RatesThe internal rate of return (r) equates the total cost of an investment project with the future net cash flows (NCF) expected from that project discounted back to their present values.Cost of project =The Demand for Investment Funds continuedAnother method of investment analysis is the net present value (NPV) approach.The Classical Theory of Interest RatesThe Cost of Capital and the Business Investment DecisionA15%B12%C10%D8%E7%Dollar Cost of Investment ProjectsExpected Internal Rates of Return on Alternative Investment ProjectsCost of Capital Funds = 10%C10%D8%E7%– acceptable– acceptable– indifferentunprofitableunprofitableThe Classical Theory of Interest RatesThe Investment Demand ScheduleIn the Classical Theory of Interest Ratesr2InterestRateInvestmentSpendingr1I1I2The Classical Theory of Interest RatesThe Equilibrium Rate of Interest In the Classical TheoryInterestRateSavings &InvestmentrEQEInvestmentSavingsThe Classical Theory of Interest RatesLimitationsFactors other than savings and investment that affect interest rates are ignored. For example, many financial institutions can “create” money today by making loans to the public.Today, economists recognize that income is more important than interest rates in determining the volume of savings. The Classical Theory of Interest RatesIn addition to the business sector, both consumers and governments are also important borrowers today.Limitations continuedThe Liquidity Preference (Cash Balances) Theory of Interest RatesThe liquidity preference (or cash balances) theory of interest rates is a short-term theory that was developed for explaining near-term changes in interest rates, and hence, is more relevant for policymakers.According to the theory, the rate of interest is the payment to money (cash balances) holders for the use of their scarce resource (liquidity), by those who demand liquidity (i.e. money or cash balances).The Liquidity Preference (Cash Balances) Theory of Interest RatesThe demand for liquidity stems from: the transactions motive - the purchase of goods and servicesthe precautionary motive - to cope with future emergencies and extraordinary expensesthe speculative motive - a rise in interest rates results in lower bond prices and  depend on the level of national income, business sales, and prices (but not interest rates). So, demand due to  and  is fixed in the short term.Speculative Demand for Money or Cash BalancesThe Total Demand for Money or Cash BalancesAnd the Equilibrium Rate of InterestThe Liquidity Preference (Cash Balances) Theory of Interest RatesIn modern economies, the money supply is controlled, or at least closely regulated, by the government.The supply of money (cash balances) is often assumed to be inelastic with respect to interest rates, since government decisions concerning the size of the money supply should presumably be guided by public welfare.The Liquidity Preference (Cash Balances) Theory of Interest RatesThe Equilibrium Interest RateIn the Liquidity Preference TheoryInterestRateQuantity ofMoney / CashBalancesEquilibrium interest rate TotalDemandQEMoneySupplyThe Liquidity Preference (Cash Balances) Theory of Interest RatesLimitationsThe liquidity preference theory is a short-term approach. In the longer term, the assumption that income remains stable does not hold.Only the supply and demand for money is considered. A more comprehensive view that considers the supply and demand for credit by all actors in the financial system - businesses, households, and governments - is needed.The Loanable Funds Theory of InterestThe popular loanable funds theory argues that the risk-free interest rate is determined by the interplay of two forces:the demand for credit (loanable funds) by domestic businesses, consumers, and governments, as well as foreign borrowersthe supply of loanable funds from domestic savings, dishoarding of money balances, money creation by the banking system, as well as foreign lendingThe Loanable Funds Theory of InterestThe Demand for Loanable FundsConsumer (household) demand is relatively inelastic with respect to the rate of interest.Domestic business demand increases as the rate of interest falls.Government demand does not depend significantly upon the level of interest rates.Foreign demand is sensitive to the spread between domestic and foreign interest rates.The Loanable Funds Theory of InterestTotal Demand for Loanable Funds (Credit)InterestRateAmount ofLoanable FundsTotal Demand = Dconsumer + Dbusiness + Dgovernment + DforeignThe Loanable Funds Theory of InterestThe Supply of Loanable FundsDomestic Savings. The net effect of income, substitution, and wealth effects is a relatively interest-inelastic supply of savings curve.Dishoarding of Money Balances. When individuals and businesses dispose of their excess cash holdings, the supply of loanable funds available to others is increased. The Loanable Funds Theory of InterestCreation of Credit by the Domestic Banking System. Commercial banks and nonbank thrift institutions offering payments accounts can create credit by lending and investing their excess reserves. Foreign lending is sensitive to the spread between domestic and foreign interest rates.The Supply of Loanable Funds continuedThe Loanable Funds Theory of InterestTotal Supply of Loanable Funds (Credit)InterestRateAmount ofLoanable FundsTotal Supply = domestic savings + newly created money + foreign lending – hoarding demandThe Loanable Funds Theory of InterestThe Equilibrium Interest RateInterestRateAmount ofLoanable FundsrEQEDemandSupplyThe Loanable Funds Theory of InterestAt equilibrium:Planned savings = planned investment across the whole economic systemMoney supply = money demandSupply of loanable funds = demand for loanable fundsNet foreign demand for loanable funds = net exportsThe Loanable Funds Theory of InterestInterest rates will be stable only when the economy, money market, loanable funds market, and foreign currency markets are simultaneously in equilibrium.Changes in the Demand for and Supply ofLoanable FundsChanges in the Demand for and Supply ofLoanable FundsThe Rational Expectations Theory of InterestThe rational expectations theory builds on a growing body of research evidence that the money and capital markets are highly efficient in digesting new information that affects interest rates and security prices.The Rational Expectations Theory of InterestThe public forms rational and unbiased expectations about the future demand and supply of credit, and hence interest rates.InterestRateAmount ofLoanable FundsrEQEExpected DemandExpected SupplyThe Rational Expectations Theory of InterestIf the money and capital markets are highly efficient, then interest rates will always be very near their equilibrium levels, and the optimal forecast of next period’s interest rate is the current interest rate.Interest rates will change only if entirely new and unexpected information appears, and the direction of change depends on the public’s current set of expectations.Expected Demand for and Supply of Loanable FundsThe Rational Expectations Theory of InterestLimitationsAt the moment, we do not know very much about how the public forms its expectations.The cost of gathering and analyzing information relevant to the pricing of assets is not always negligible, as assumed.Not all interest rates and security prices appear to display the kind of behavior implied by the rational expectations theory.Markets on the NetBank Rate.com at www.bankrate.comBond Market Association at www.investinginbonds.comCNN/Money at www.cnnfn.comEuropean Central Bank at www.ecb.int/Federal Reserve System at www.federalreserve.govNational Endowment for Financial Education at www.nefe.orgChapter ReviewIntroduction: Interest Rates and the Price of CreditFunctions of the Interest Rate in the EconomyThe Classical Theory of Interest RatesSavings by Households, Business Firms and GovernmentsThe Demand for Investment FundsThe Equilibrium Interest RateLimitations of the Classical TheoryChapter ReviewThe Liquidity Preference or Cash Balances Theory of Interest RatesThe Demand for LiquidityThe Supply of Money (Cash Balances)The Equilibrium Interest RateLimitations of the Liquidity Preference TheoryChapter ReviewThe Loanable Funds Theory of InterestThe Demand for Loanable FundsThe Supply of Loanable FundsThe Equilibrium Interest RateThe Rational Expectations Theory of Interest