(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.