Chapter 2: Determinants of Interest Rates

Financail Markets & Institutions

Interest Rate

The cost of borrowing money, expressed as a percentage of the principal.

What is an interest rate and why is it important?

The value of the next best alternative forgone when making a financial decision.

Opportunity Cost

How does opportunity cost factor into interest rates?

The risk that a borrower will not repay a loan as promised.

Credit Risk

: The risk that a borrower will not repay a loan as promised.

Why does credit risk increase interest rates?

Liquidity Needs

The need for immediate access to cash, affecting willingness to lend.

How do liquidity needs influence the level of interest rates?

Delayed Consumption

Postponing present spending in exchange for future returns

Why is delayed consumption considered when determining interest rates?

Consumer Finance

Area where interest rates affect mortgages, auto loans, credit cards, and student loans

Name two areas of consumer finance influenced by interest rates

Corporate Finance

Area where interest rates influence cost of capital, valuation, and debt issuance.

How do interest rates affect corporate finance?

Financial Markets

Markets where interest rates influence bond prices, stocks, and For EX

Why do financial markets react strongly to interest rate changes?

Banking

Sector where interest rates affect profit margins and lending activity

How do banks benefit or lose from changing interest rates?

Real Estate

Sector where interest rates affect property prices and liquidity.

How do interest rates influence real estate values?

Loanable Funds Theory

Theory stating that interest rates are determined by the supply and demand of loanable funds

What does the loanable funds theory explain about interest rates?

Supply of Loanable Funds

The amount of funds households, businesses, and foreigners are willing to save/lend

What factors increase the supply of loanable funds?

Demand for Loanable Funds

The amount of funds households, businesses, and governments want to borrow.

What increases the demand for loanable funds?

Household Saving

Determined by interest rates, income, wealth, and cultural attitudes toward saving

What factors influence how much households save?

Household Borrowing

Driven by desire for housing, cars, education, and consumption.

What are common reasons households borrow money?

Foreign Supply of Funds

Driven by relative interest rates, exchange rate expectations, and safe haven status

Why do foreigners supply funds to U.S. markets?

Foreign Demand for Funds

U.S. investments abroad made possible by functioning capital markets

Why do foreigners demand U.S. funds?

Business Saving

Businesses save when they have excess liquidity temporarily.

Why might businesses choose to save funds rather than invest?

Business Borrowing

Driven by positive NPV projects, economic growth, and stability

What determines business demand for funds?

Government Saving

Governments rarely save; deficits drive borrowing.

Why does government typically demand funds instead of supplying them?

Government Borrowing

Borrowing occurs when spending exceeds tax revenue

Why is government borrowing considered a tautology?

Wealth and Income

Higher wealth and income increase supply of funds and lower interest rates.

How do wealth and income affect interest rates?

Risk

Higher risk decreases supply and demand, raising interest rates.

How does investment risk shift supply and demand for funds?

Near-Term Spending Needs

Higher current needs reduce supply of funds, raising interest rates.

Why do short-term spending needs reduce fund supply?

Monetary Expansion

Central bank action that increases money supply, lowering interest rates

How does monetary expansion affect interest rates?

Economic Growth

Increases both supply and demand for funds, with indeterminate effect on rates.

Why can economic growth raise interest rates?

Utility from Assets

Increases demand but reduces supply, raising interest rates.

Why does higher utility from owning assets increase rates?

Restrictive Covenants

Loan restrictions that reduce borrower demand, lowering interest rates.

How do restrictive covenants impact borrowing demand?

Taxes

Taxes reduce supply of funds but increase demand through deductibility of interest.

How do taxes affect saving and borrowing behavior?

Currency Appreciation

Attracts foreign supply of funds, lowering interest rates.

Why does currency appreciation increase fund supply?

Expected Inflation

Reduces supply but increases demand, raising interest rates.

How does expected inflation influence interest rates?

Term Structure of Interest Rates

Relationship between interest rates and maturity lengths

Why are longer-term loans usually associated with higher interest rates?