Transcript International Finance

Unit 8. Determination of Interest
Rates Movements
• The loanable funds theory, is commonly used to explain
interest rate movements, suggests that the market interest
rate is determined by the factors that control the supply of
and demand for loanable funds.
• The phrase “demand for loanable funds” is widely used
in financial markets to refer to the borrowing activities of
households, businesses, domestic governments and
foreign governments and corporations.
interest rate movements, suggests that the market interest
rate is determined by the factors that control the supply of
and demand for loanable funds.
• The loanable funds theory, is commonly used to explain
interest rate movements, suggests that the market interest
I. Demand for Loanable Funds
(a)household demand for loanable funds;
Demand
For
Loanable
funds
(b) corporate demand for loanable funds;
(c) government demand for loanable funds;
(d) foreign demand for loanable funds.
A. Household Demand for Loanable Funds
• Households commonly demand loanable funds to finance
housing expenditures, automobiles and household items, which
results in installment debt.
• There would be an inverse relationship between the interest rate
and the quantity of household funds demanded. This simply
implies that at any point in time, households would demand a
greater quantity of loanable funds at lower rates of interest.
• Various events can cause household borrowing preferences to
change, for example, if tax rates on household income are
expected to significantly decrease in the future, households might
believe that they can more easily afford future loans repayments
and thus be willing to borrow more funds.
B. Business Demand for Loanable Funds
• Businesses demand loanable funds to invest in long-term (fixed)
and short-term assets. The quantity of funds demanded by
businesses depends on the number of business projects to be
implemented.
• Businesses evaluate a project by comparing the present value of
its cash flows to its initial investment. Projects with a positive
net present value (NPV/ 净 现 值 ) are accepted because the
present value of their benefits outweighs the costs. The required
return to implement a given project will be lower if interest rates
are lower because the cost of borrowing funds to support the
project would be lower. Consequently, more projects will have
positive NPVs, and businesses will need a greater amount of
financing. This implies that businesses will demand a greater
quantity of loanable funds when interest rates are lower.
• In addition to long-term assets, businesses also invest
in short-term assets (such as account receivables and
inventory) in order to support ongoing operations. Any
demand for funds resulting from this type of
investment is positively related to the number of
projects implemented and thus inversely related to the
interest rate. All businesses are likely to demand more
funds if interest rates are lower at a given point in time.
• Some events may affect the business demand for
loanable funds, for instance, a lot of projects will be
acceptable as a result of more favorable economic
forecasts, causing an increased demand for loanable
funds.
C. Government Demand for Loanable Funds
• Whenever a government’s expenditures can not be
completely covered by its incoming revenues from taxes and
other sources, it demands loanable funds, and the government
will issue treasury securities, which represents government
debt.
• The government demand for funds is said to be interestinelastic or insensitive to interest rates. Like the household
and business demand, the government demand for loanable
funds are affected by various events. For instance, assume
that new bills were passed that caused a net increase in the
deficit of $20 billion, the government demand for loanable
funds would increase by that amount, and the new demand
for loanable funds would decrease if the government budget
deficit were reduced.
D. Foreign Demand for Loanable funds
• The demand for loanable funds in a given market also includes
foreign demand by foreign governments or corporations. Foreign
governments and corporations would demand a larger quantity of
domestic funds if their own interest rates were higher relative to
domestic rates.
For instance, the British government may obtain financing by
issuing British treasury securities to U.S. investors, representing a
British demand for U.S. funds. British demand for U.S. funds is
influenced by the differential between its interest rates and U.S.
rates.
Therefore, for a given set of foreign interest rates, the quantity
of domestic loanable funds demanded by foreign governments or
firms will be inversely related to domestic interest rate.
Note:
Based on the above analysis, because
most of these sectors are likely to demand a
larger quantity of funds at lower interest rates,
the aggregate demand for loanable funds is
inversely related to interest rates at any point
in time.
II. Supply of Loanable Funds
•
The term “supply of loanable funds” is
commonly used to refer to funds provided to
financial markets by savers.
Supply
of
Loanable
funds
(a) The household sector is the largest supplier;
(b) The loanable funds are supplied by some
government units that temporarily generate
more tax revenues than they spend;
(c) The loanable funds are supplied by some
businesses whose cash inflows exceed
outflows.
Note:
Households as a group represent a
net supplier of loanable funds, whereas
governments and businesses are net
demanders of loanable funds.
• Suppliers of loanable funds are willing to supply more funds if the
interest rate (reward for supplying funds) is higher, other things being
equal. A supply of loanable funds exists at even a very low interest rate
because some households choose to postpone consumption until later
years, even when reward (interest rate) for saving is low. Foreign
households, governments, and corporations commonly supply funds to
domestic markets by purchasing domestic securities.
• The supply of loanable funds is also influenced by the monetary policy
by the domestic central bank, which controls the amount of reserves
hold by depository institutions and can influence the amount of savings
that can be converted into loanable funds.
• Note that minimal attention has been given to financial institutions in
this section. Although financial institutions play a critical intermediary
role in channeling funds, they do not represent the ultimate suppliers of
funds. Any change in the financial institution’s supply of funds results
only from a change in habits by the households, businesses or
governments that supply the funds.
III. Equilibrium Interest Rate
Graph A
Graph B
In equilibrium, Da = Sa (Da represents aggregate
demand and Sa represents aggregate supply):
(a) If the aggregate demand for loanable funds
increases without a corresponding increase in aggregate
supply, there will be a shortage of loanable funds.
Interest rates will rise until an additional supply of
loanable funds is available to meet the excess demand.
(b) If the aggregate supply of loanable funds increases
without a corresponding increase in aggregate demand,
there will be a surplus of loanable funds. Interest rates
will fall until the quantity of funds supplied no longer
exceeds the quantity of funds demanded.