Financial Markets (Bilingual Teaching)
relationship between interest rates and the quantity of loanable funds demanded.
2) Businesses demand loanable funds to invest in assets;
Projects with a positive NPV are accepted because the present value of their benefits outweighs their costs;There is an inverse relationship between interest rates and the quantity of loanable funds demanded.
3) When planned expenditures exceed revenues from taxes,
the government demands loanable funds; Government demand for funds is interest-inelastic.
a) Municipal (state and local) governments issue municipal bonds
b) Federal government and its agencies issue Treasury securities and federal agency securities
4) A foreign country’s demand for U.S. funds is influenced
by the differential between its interest rates and U.S. rates; The quantity of U.S. loanable funds demanded by foreign investors will be inversely related to U.S. interest rates. 5) The aggregate demand for loanable funds is the sum of the
quantities demanded by the separate sectors; The aggregate demand for loanable funds is inversely related to interest rates
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Financial Markets (Bilingual Teaching)
4. Sector Supply of Loanable Funds
1) Households are major suppliers of loanable funds 2) Businesses and governments may invest (loan) funds
temporarily
3) Foreign sector a net supplier of funds in last twenty years 4) Federal Reserve’s monetary policy impacts supply of
loanable funds
5. Equilibrium Interest Rate
Aggregate Demand: DA = Dh + Db + Dg + Dm + Df Aggregate Supply: SA = Sh + Sb + Sg + Sm + Sf In equilibrium, DA = SA Interest Rates
Quantity of Loanable Funds
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Supply of
Loanable Funds
Demand for Loanable Funds
Financial Markets (Bilingual Teaching)
6. General Equilibrium Interest Rate
1) Interest rate level where quantity of aggregate loanable
funds demanded = supply 2) Surplus and shortage conditions
? Surplus- Quantity demanded < quantity supplied followed by market interest rate decreases
? Shortage- Government interest rate ceilings below market interest rates
7. Key Factors Impacting Interest Rates Over Time 1) Economic Growth--Increased growth; increased demand
for funds; interest rates increase
2) Expected inflation--If inflation is expected to increase:
? Households may reduce their savings to make purchases before prices rise; Supply shifts to the left, raising the equilibrium rate
? Also, households and businesses may borrow more to purchase goods before prices increase; Demand shifts outward, raising the equilibrium rate
? The Fisher Effect: Nominal Interest Rates = Sum of Real Rate plus Expected Rate of Inflation: in=ir+E(I)
3) Government budgets
? Deficit—increase borrowing; security prices fall,
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Financial Markets (Bilingual Teaching)
interest rates increase
? Increase in deficit increases the quantity of loanable funds demanded; Government is willing to pay whatever is necessary to borrow funds, ―crowding out‖ the private sector
? Surplus—decreased borrowing; security prices increase; interest rates decrease
4) Money Supply--When the Fed increases the money supply,
it increases supply of loanable funds; Places downward pressure on interest rates
5) Increased foreign supply of loanable funds—security
prices increase; interest rates decrease
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Financial Markets (Bilingual Teaching)
Chapter3 Structure of Interest Rates
1. Factors Affecting Security Yields
Increased riskiness generates lower security prices or higher investor required rates of return:
1) Default risk (also called Credit Risk)
2) Liquid: A liquid investment is easily converted to cash At minimum transactions cost; Investors pay more (lower yield) for liquid investment
3) Tax status: Investors require higher yields For higher taxed securities; Yat = Ybt(1 – T)
4) Term to maturity: Interest rates typically vary by maturity. The term structure of interest rates defines the relationship between maturity and yield. The Yield Curve is the plot of current interest yields versus time to maturity.
5) Special Provisions: Special contract provisions such as embedded options
? Call Feature: enables borrower to buy back the bonds before maturity at a specified price; Call features are exercised when interest rates have declined; Investors demand higher yield on callable bonds, especially when rates are expected to fall in the future
? Convertible bonds: Convertibility feature allows
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