Determination of Interest Rates

Flashcards covering the determination of interest rates, including the Loanable Funds Theory, various demands and supplies of funds, the equilibrium interest rate, and factors influencing interest rate movements like economic growth, inflation, monetary policy, budget deficits, and foreign funds flows.

Loanable Funds Theory

Suggests that the market interest rate is determined by the factors that control the supply of and demand for loanable funds.

Household Demand for Loanable Funds

The demand for loanable funds by households to finance housing, automobile, and other household expenditures, which has an inverse relationship with the interest rate.

Business Demand for Loanable Funds

The demand for loanable funds by businesses for implementing projects, with more demand occurring at lower interest rates.

Government Demand for Loanable Funds

The demand for loanable funds by governments when planned expenditures are not covered by incoming revenues, characterized as interest inelastic.

Interest Inelastic (Government Demand)

Refers to government demand for loanable funds being insensitive to interest rates, as expenditures and tax policies are independent of interest rate levels.

Foreign Demand for Loanable Funds

A country's demand for foreign funds, which depends on the interest rate differential between two countries and is inversely related to U.S. interest rates for foreign entities demanding U.S. funds.

Aggregate Demand for Loanable Funds

The sum of the quantities demanded by all separate sectors (households, businesses, federal government, municipal government, and foreign entities) at any given interest rate.

Supply of Loanable Funds

Provided primarily by households, with more funds typically supplied at higher interest rates; also affected by government units and the Fed's monetary policy.

Aggregate Supply of Loanable Funds

The combination of all sector supply schedules along with the supply of funds provided by the Fed’s monetary policy.

Equilibrium Interest Rate

The interest rate at which the aggregate supply of loanable funds is equal to the aggregate demand for loanable funds.

Surplus of Loanable Funds

Occurs when the interest rate is above the equilibrium interest rate, meaning the supply of loanable funds exceeds the demand.

Shortage of Loanable Funds

Occurs when the interest rate is below the equilibrium interest rate, meaning the demand for loanable funds exceeds the supply.

Impact of Economic Growth on Interest Rates

Puts upward pressure on interest rates by shifting the demand for loanable funds outward due to increased business projects and household expenditures.

Impact of Inflation on Interest Rates

Puts upward pressure on interest rates by shifting the supply of funds inward (savers require higher returns) and demand for funds outward (borrowers anticipate repaying with cheaper dollars).

Fisher Effect

States that the nominal or quoted interest rate (i) equals the expected inflation rate (E(INF)) plus the real interest rate (iR), represented as i = E(INF) + iR.

Impact of Monetary Policy on Interest Rates

When the Fed reduces (increases) the money supply, it reduces (increases) the supply of loanable funds, putting upward (downward) pressure on interest rates.

Crowding-out Effect

Given a certain amount of loanable funds supplied to the market, excessive government demand for funds tends to reduce or 'crowd out' the private demand for funds.

Impact of Foreign Flows of Funds on Interest Rates

The interest rate for a certain currency is determined by the demand for funds in that currency and the supply of funds available in that currency.