(2a) Interest Rates (part 1) (2)

FIN 325: Financial Institutions and Markets

Overview

  • Course Title: FIN 325 Financial Institutions and Markets

  • Instructor: Professor Greg Nini

  • Institution: LeBow College of Business, Drexel University

  • Term: Winter 2025

Interest Rates: Definition and Determination

  • What is an Interest Rate?

    • Price paid by borrower to lender for the use of funds.

    • Lender acts as the supplier of funds; borrower is the demander.

  • How are Interest Rates Determined?

    • Part 1: Short-term interest rates.

    • Part 2: Term structure of interest rates.

    • Part 3: Interest rate risk.

Relevant Readings

  • Chapters & Articles:

    • SC Chapter 2: Loanable Funds Theory.

    • "Hutchins Center Commentary: What is the neutral rate of interest?" by Boocker, Ng, and Wessel.

Plan of Study

  1. Short-term interest rates.

  2. Supply and demand for loanable funds.

  3. Components of supply and demand.

  4. Using the model.

Short-Term Interest Rates

  • Risk-Free Rate: Represents the short-term interest rate without risk.

The Role of the Federal Reserve

  • Federal Funds Rate (Fed):

    • Interest rate on overnight loans from one bank to another.

    • Other short-term rates adjust to be close to this rate.

    • The Fed influences short-term, risk-free rates.

    • Opportunity Cost: Important consideration in rate setting.

Choosing the Federal Funds Rate

  • Dual Mandate of the Fed:

    • Stable employment.

    • Stable prices.

  • Target Rate Determination:

    • Neutral rate of interest.

    • Fed's policy objectives (boost economy vs. slow inflation).

Neutral Rate of Interest

  • Definition: The interest rate that exists when monetary policy is neutral.

  • Impact of Federal Reserve Actions:

    • Depends on actual interest rates relative to the neutral rate.

    • Example: Lowering inflation by setting FF Rate above neutral.

  • Quote by Lael Brainard (Former Vice Chair of Fed):

    • Nominal neutral interest rate aligns with a balanced growth in output within stable inflation.

Economic Outlook and Policy Stance

  • Quote by Jay Powell (Chair of Fed):

    • Current policy is seen as restrictive, affecting economic activities, hiring, and inflation.

Supply and Demand for Loanable Funds

  • Loanable Funds Definition: Savings of investors used for borrowing and investment.

  • Price of Loanable Funds: Determined by interest rates.

  • Sources of Supply and Demand:

    • Households, firms, government, and the rest of the world.

Supply and Demand Components

  • Supply of Funds:

    • Mainly from household savings and foreign purchases of U.S. assets.

  • Demand for Funds:

    • Determined by households, firms, and government spending needs;

    • Influenced by interest rates.

Shifts in Supply and Demand

  • Interest rates are affected by economic fundamentals:

    • Recession leading to decreased investment and increased savings.

    • Inflation dynamics can alter supply of loanable funds.

Inflation Impacts on Interest Rates

  • Inflation: General increase in prices, complicating saving due to its cost.

  • Real Rate of Interest:

    • Calculated using the formula: Real Rate = Nominal Rate - Inflation.

Income Growth and Interest Rates

  • Income expectations drive savings behavior:

    • High expected income suggests higher savings rates, impacting the interest rates accordingly.

Summary of Key Takeaways

  • Interest rates are shaped by supply and demand dynamics.

  • The Federal Reserve establishes policy rates in relation to the neutral rate.

  • Households typically supply funds, while firms are primary beneficiaries.

  • Inflation diminishes the effective supply of savings leading to higher nominal interest rates in response.