BFMS L02 Theory And Structure Of Interest Rates

Banking, Financial Markets and Systems
Set - 2
Theory and Structure of Interest rates
P C Narayan

IIMB PCN BFMS L02

1

Loanable Funds theory
“Market interest Rate is determined by the factors that control the supply and demand for loanable funds”

IIMB PCN BFMS L02

2

1

Demand for Loanable Funds
• Household demand for loanable funds
– As household income rises, so does installment debt
– Inverse relationship between demand for lonable funds and interest rate

• Business demand for loanable funds
– Inverse relationship between demand for lonable funds and interest rate

• Government demand for loanable funds
– Interest inelastic since borrowing to meet deficit

• Foreign demand for loanable funds
– Country A issues securities to investors of country B

• Total Demand for lonable funds Da =
Dh + Db + Dg + Df
IIMB PCN BFMS L02

3

Supply of Loanable Funds
• Household sector is the largest followed by
Government and Business (Sa)
• Directly proportional to interest rates
_______________________________________
In equilibrium, Da = Sa
• And the interest rate at this point is is known as
‘equilibrium interest rate’
• Change in demand or supply causes a change in
‘equilibrium interest rate’
IIMB PCN BFMS L02

4

2

Fisher Effect
• Offers an additional explanation to the loanable funds theory
• Nominal Interest rate
– Compensates for reduced purchasing power
– Provides a premium for foregoing present consumption

• (1+In ) = (1+ir)*(1+E(i))
• Which can be simplified as

In = ir + E(i)

where in is the Nominal interest rate

ir is the Real interest rate
E(i) is the Expected inflation

• Since ir cannot be negative, higher inflation tends to push up interest rates
IIMB PCN BFMS L02

5

Key issues impacting Interest rates
• Impact of Inflation
• Impact of budget deficit
• Impact of foreign interest rates

IIMB PCN BFMS L02

6

3

Term Structure of Interest rates
• Relationship between term to maturity and annualised yield
• ‘Pure Expectations’ theory
• ‘Liquidity