Institutions Ch 2

Nominal interest rates

are the interest rates actually observed in financial markets

Nominal interest rates are the interest rates actually observed in financial markets

• Directly affect the value (price) of most securities traded in the money and capital markets

• Changes in interest rates influence the performance and decision making for individual investors, businesses, and governmental units

Changes in interest rates impact security values

FIs (Financial Institutions) spend much time and effort trying to identify factors that determine the level of interest rates at any moment in time, as well as what causes interest rate movements over time

Loanable funds theory

views equilibrium interest rates in financial markets as a result of the supply of and demand for loanable funds

Loanable funds theory views equilibrium interest rates in financial markets as a result of the supply of and demand for loanable funds

Categorizes financial market participants – consumers, businesses, governments, and foreign participants – as net suppliers or demanders of funds

“Supply of loanable funds”

describes funds provided to the financial markets by net suppliers of funds

• Generally, the quantity of loanable funds supplied increases as interest rates rise

Generally, the quantity of loanable funds supplied increases as interest rates rise

• Household sector (consumer sector) is one of the largest suppliers of loanable funds in the U.S. ($84.66t in 2019)

• Business sector often has excess cash that it can invest for short periods of time ($28.06t for nonfinancial and $98.47t for financial business in 2019)

• Governments may supply loanable funds ($5.66t in 2019)

• Foreign investors view U.S. markets as alternatives to their domestic financial markets ($27.20t in 2019)

Supply of and Demand for Loanable Funds

“Demand for loanable funds”

describes the total net demand for funds by fund users

• In general, the quantity of loanable funds demanded is higher as interest rates fall

In general, the quantity of loanable funds demanded is higher as interest rates fall

• Household demand reflects financing purchases of homes, durable goods, and nondurable goods ($16.05t in 2019)

• Businesses demand funds to finance investments in long-term assets and for short-term working capital needs ($66.46t for nonfinancial and $111.87t for financial in 2019)

• Governments also borrow heavily ($28.86t in 2019)

• Foreign participants, mostly from the business sector, borrow in U.S. financial markets ($20.81t in 2019)

Factors that cause the supply curve of loanable funds to shift, at any given interest rate:

1. As wealth of fund suppliers increases (decreases), the supply of loanable funds increases (decreases)

2. As risk of the financial security increases (decreases), the supply of loanable funds decreases (increases) 

3. As near-term spending needs increase (decrease), the supply of loanable funds increases (decreases)

4. When monetary policy objectives allow the economy to expand (restrict expansion), the supply of loanable funds increases (decreases)

5. As economic conditions improve in a domestic (foreign) country, the supply of funds increases (decreases)

Factors that cause the demand curve for loanable funds to shift include the following:

1. As the utility derived from an asset purchased with borrowed funds increases (decreases), the demand for loanable funds increases (decreases)

2. As the restrictiveness of nonprice conditions on borrowed funds decreases (increases), the demand for loanable funds increases (decreases)

   • Nonprice conditions may include fees, collateral, or requirements or restrictions on the use of funds (i.e., restrictive covenants)

3. When domestic economic conditions result in a period of growth (stagnation), the demand for funds increases (decreases)