SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM AND THE ECONOMY (part 14)

The Determinants of Interest Rates

by

Charles Lamson

In the previous articles, I have emphasized the role of the financial system in coordinating and channeling the flow of funds from surplus spending units (SSUs or households) to deficit spending units (DSUs or firms). The interest rate is of paramount importance in this process for the following reasons: (1) Since it is the reward for lending and the cost of borrowing and lending, that is, the behavior of DSUs and SSUs; and (2) conversely, the borrowing and lending behavior of DSUs and SSUs influences the interest rate. In the market for loanable funds, as in other markets, supply and demand are the key to determining interest rates. This means, of course, that any change in interest rates will be the result of changes in supply and/or demand.

The demand for loanable funds originates from the household, business, government, and foreign DSUs who borrow because they are spending more than their current income. The downward-sloping demand curve indicates that DSUs are willing to borrow more at lower rates, ceteris paribus (all things remaining equal). Businesses borrow more at lower interest rates because more investment projects become profitable, ceteris paribus. Projects that would be unprofitable if the business had to pay 12 percent to borrow the funds become quite profitable if the funds can be had for only 2 percent. Consumers borrow more at lower interest rates, ceteris paribus, for such things as automobiles and other consumer durables.

The total supply of loanable funds originates from two basic sources: (1) the household, business, government, and foreign SSUs who are prepared to lend because they are spending less than their current income, and (2) the Fed, which, in its ongoing attempts to manage the economy's performance, supplies reserves to the financial system that lead to increases in the growth rate of money (and loans). We shall assume that the Fed's supply of funds is fixed at a particular amount for the time being. Adding the funds that SSUs are willing to supply to the Fed's supply of funds produces a supply curve for loanable funds that is upward sloping. This indicates that SSUs are willing to supply more funds at higher rates, ceteris paribus. as Exhibit 1 shows, the quantity of funds supplied equals the quantity of funds demanded at point E1. The equilibrium interest rate in the market for loanable funds is 6 percent, and the equilibrium quantity of funds borrowed and lent is $500 billion.

The interest rate is measured on the vertical axis, while the quantity of loanable funds is measured on the horizontal axis. At E1, the quantity is equal to the quantity supplied, and the market is in equilibrium. The supply of and demand for loanable funds determines the interest rate.

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From the point of view of our portfolio manager, it is not sufficient to know the equilibrium or current interest rate. What is really of concern is the potential for future changes in interest rates and the capital gains (increases in bond prices) or capital losses (decreases in bond prices) that will accompany such changes. Since any change in interest rates will be the result of a change in either the supply of or demand for funds, let us take a close look at the major factors that can shift either of the curves.

Changes in the Demand for Loanable Funds

On the demand side, research has shown that movements in gross domestic product (GDP) are a major determinant in shifts in the demand for funds. In particular, when GDP rises, ceteris paribus, for example, both firms and households become more willing and able to borrow. Firms are more willing because the rise in GDP has improved the business outlook, encouraging them to expand planned inventories and engage in more investment spending, such as purchases of plant and equipment. Households are more willing to borrow because the rise the rise in GDP has increased their incomes and/or improved the employment outlook. These factors encourage them to increase their purchases of goods and services, particularly autos, other durable goods, and houses, which often require some financing. Both firms and households are more able to borrow because the improved economic outlook and the rise in incomes will make it easier to make the interest and principal payments on any new debt. Another factor that affects the demand for loanable funds is an increase in the anticipated productivity of capital investments. Anticipated increases in productivity lead to a greater demand for capital investments and hence increase the demand for loanable funds.

The effect of an increase in the demand for funds resulting from a rise in income or an anticipated increase in productivity of capital investment is shown in Exhibit 2. The demand for funds shifts from DD to D1. Previously, the quantity of funds supplied was equal to the quantity of funds demanded at point E1: the equilibrium interest rate prevailing in the market was 6 percent, and the quantity of funds borrowed was $500 billion. When the demand curve shifts to the right, ceteris paribus, a disequilibrium develops in the market. More specifically, at the prevailing 6 percent rate, the quantity of funds demanded exceeds the quantity supplied. Given the excess demand, the interest rate rises. The higher interest rate induces SSUs to increase the quantity of loanable funds they are willing to supply (a movement along the supply curve). Such changes in plans help to close the gap between quantity demanded and quantity supplied, and a new equilibrium is essentially established at point E2 where the interest rate is 8 percent and the quantity of funds borrowed and lent is $600 billion. To sum up, we start with an equilibrium, demand increases, ceteris paribus, creating a disequilibrium, the interest rate goes up, and a new equilibrium is established.

Changes in the Supply of Funds

On the supply side, as you already know, one of the factors determining supply of loanable funds is monetary policy. In particular, the Fed's ability to alter the growth rate of money in the economy. It means it can have a direct effect on the cost and availability of funds. To illustrate, a Fed-engineered increase in the supply, as shown in Exhibit 3, shifts the supply curve from SS to S1, ceteris paribus. This creates a disequilibrium: the quantity supplied of funds exceeds the quantity demanded of funds at the prevailing 6 percent interest rate. The excess quantity supplied puts downward pressure on interest rates. As interest rates fall, DSUs and SSUs revise their borrowing and lending plans. For example, as the cost of borrowing falls, DSUs will be induced to borrow a larger quantity (a movement along a demand curve). Such actions, which serve to narrow the gap between quantity supplied and quantity demanded, will continue until a new equilibrium is established at point E2. The result is a fall in the interest rate from 6 percent to 4 percent and an increase in the quantity demanded from $500 billion to $550 billion. In sum, the money growth supply rate and the interest rate are inversely related, ceteris paribus. Holding other things constant, an increase in the money supply will lower the interest rate, while a decrease in the money supply will raise the interest rate via the effect of changes in the growth rate of the money supply on the supply of loanable funds.

The graphical analysis illustrates the relationship between changes in the supply of loanable funds and interest rates. However, graphs by themselves explain little and prove nothing. If the illustration is really going to aid your understanding, you need to be able to breath some life into the picture by knowing how and why the interest rate changes; that is, what is the mechanism or process that produces this result? The answer in this case is quite simple. Visualize financial intermediaries in the economy, particularly depository institutions, as having more funds to lend as a result of the Fed's action increasing the money supply. In general, the intermediaries will use these funds to acquire interest-earning assets---securities and loans, in particular. If they demand more securities (bonds), this will raise the price and lower the yield to maturity on outstanding bonds, ceteris paribus. If the intermediaries want to extend loans, they will have to induce households and firms to borrow more than they are currently borrowing or planning to borrow. How can this be accomplished? If you said, "Lower the rates charged on loans," you are correct. Thus, the movement from E1 to E2 in Exhibit 3 is not a sterile hop to be memorized and reproduced in response to some exam questions. It depicts a process and a series of transactions, including the acquisition of securities, extension of loans, and accompanying changes in interest rates that are at the heart of the operations of the financial system and its role in the economy.

Recap

The demand for loanable funds originates from DSUs. The quantity demanded is inversely related to the interest rate. The supply of loanable funds originates from SSUs and from the Fed, which supplies reserves to the banking system. The quantity supplied is directly related to the interest rate. If incomes increase, the demand for loanable funds increases. If the money supply increases, the supply of loanable funds increases and the interest rate falls.

*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 136-140*

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