FINANCIAL INSTITUTIONS & MARKETS

CH03: INTEREST RATES IN THE FINANCIAL SYSTEM

CHAPTER THREE
3. INTEREST RATES IN THE FINANCIAL SYSTEM
INTRODUCTION
The acts of saving and lending, borrowing and investing are intimately (closely) linked through
the entire financial system. In addition, one factor that significantly influences and ties all of them
together is the rate of interest. The rate of interest is the price a borrower must pay to secure scarce
loan able funds from a lender for an agreed-upon time period. However, unlike other prices in the
economy, the rate of interest is really a ratio of two quantities: the money cost of borrowing
divided by the amount of money actually borrowed, usually expressed on an annual percentage
basis.
Interest rates send price signals to those who ultimately supply funds to the economy through
saving and lending and to those who ultimately demand funds by borrowing to make capital
investments in the economy. Higher interest rates provide incentives to increase the supply of
funds, but at the same time they reduce the demand for those funds.
Lower interest rates have the opposite effects. Since the total amount of funds supplied by the
financial system must just equal the total amount borrowed, that is, quantity supplied equals
quantity demanded. Then whether an increase in interest rates increases the total amount of funds
available in the economy depends on whether the supply response of savers and lenders is greater
or less than the demand response of borrowers.
3.1. Types of interest Rates
Economists talk about the rate of interest. This assumes that there is some particular interest rate
that can be taken as representative of all interest rates in an economy. The rate chosen as the
representative rate will vary depending on the question being considered. Sometimes, for example,
the discount rate on treasury bills will be taken as representative. At other times the rate of interest
on new local authority debt, the base interest rate of the retail banks, or a short-term money market
rate. We need to distinguish between nominal and real interest rates.
1. Nominal Interest Rate
The interest rates actually observed in financial markets. the interest rate makes no allowance for
inflation, and it is more precisely referred to as the nominal interest rate. The rates of interest
quoted by financial institutions are nominal rates, allowing calculation of the amounts of money

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to be received as interest by lenders or paid by borrowers. This is clearly of immediate interest to

borrowers and lenders. However, it is equally important to them to know how these amounts relate
to their existing or likely future income and to the prices of goods and services. That is, a borrower
wishes to know the opportunity cost of borrowing – how many goods and services she must forgo
in order to pay the interest on a loan.
2. Real interest rate
The nominal rate of interest minus the expected rate of inflation. It is a measure of the anticipated
opportunity cost of borrowing in terms of goods and services forgone. The interest rate that
is adjusted by subtracting expected changes in the price level (inflation) so that it more accurately
reflects the true cost of borrowing. This interest rate is more precisely referred to as the ex ante
real interest rate because it is adjusted for expected changes in the price level. The ex ante real
interest rate is most important to economic decisions, and typically it is what financial economists
mean when they make reference to the “real” interest rate. The interest rate that is adjusted for
actual changes in the price level is called the ex post real interest rate. It describes how
well a lender has done in real terms after the fact.
The real interest rate is more accurately defined by the Fisher equation, named for Irving Fisher,
one of the great monetary economists of the twentieth century. The Fisher equation states that the

nominal interest rate i equals the real interest rate ir plus the expected rate of inflation пe.

Rearranging terms, we find that the real interest rate equals the nominal interest rate minus the
expected inflation rate:

Example: What is the real interest rate if the nominal interest rate is 8% and the expected inflation
rate is 10% over the course of a year?
Solution
The real interest rate is –2%. Although you will be receiving 8% more dollars at the end of the
year, you will be paying 10% more for goods. The result is that you will be able to buy 2% fewer
goods at the end of the year, and you will be 2% worse off in real terms.

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NB: When the real interest rate is low, there are greater incentives to borrow and fewer incentives
to lend.

The Distinction between Interest Rates and Returns

The return on a bond will not necessarily equal the interest rate on that bond. The rate of return
is defined as the payments to the owner plus the change in its value, expressed as a fraction of its
purchase price.
To make this definition clearer, let us see what the return would look like for a $1,000-facevalue
coupon bond with a coupon rate of 10% that is bought for $1,000, held for one year, and then sold
for $1,200. The payments to the owner are the yearly coupon payments of $100, and the change
in its value is $1,200 – $1,000 = $200. Adding these together and expressing them as a fraction of
the purchase price of $1,000 gives us the one-year holding-period return for this bond:

However, the coupon rate is only 10%

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3.2. The Theory and structure of Interest Rates

1. Classical Theory of interest Rates

The classical theory of interest also known as the demand and supply theory was propounded by
the economists like Marshall and Fisher. Later on, Pigou, Cassel, Knight and Taussig worked to
modify the theory.

According to this theory rate of interest is determined by the intersection of demand and supply of
savings. It is called the real theory of interest in the sense that it explains the determination of
interest by analyzing the real factors like savings and investment. Therefore, “classical economists
maintained that interest is a price paid for the supply of savings”.

The classical theory argues that two forces determine the rate of interest:

1. The supply of savings , derived mainly from households, and

2. The demand for investment capital, coming mainly from the business sector.
Factors to be considered by households while making decisions on the timing and amount of
savings are;

a) Size of the current and future income

b) The desired saving targets
c) Desired proportion of income to be saved
Interest rates also affect individual choice between current consumption and saving for the future
consumption.

Assumptions of classical theory of interest:

Individuals have a definite time preference for current over the future consumption.
Individual would always prefer current enjoyment of goods and service over future
enjoyment.
Therefore, the only way to encourage an individual or family to consume less now and save more
was to offer a higher rate of interest on current saving. If more were saved in the current period at
the higher rates of return, future consumption and future enjoyment would be increased.

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 Saving by Households
 The classical theory of interest assumes that individuals have a definite time preference for
current over future consumption.
 A rational individual, it is assumed, will always prefer current enjoyment of goods and
services over future enjoyment.
 Therefore, the only way to encourage an individual or family to consume less now and
save more is to offer a higher rate of interest on current savings.
 If more were saved in the current period at a higher rate of return, future consumption
would be increased.
 The classical theory considers the payment of interest a reward for waiting-the
postponement of current consumption in favor of greater future consumption.
 Higher interest rates increase the attractiveness of saving relative to consumption spending,
encouraging more individuals to substitute current saving (and future consumption) for
some quantity of current consumption.
 This so-called substitution effect calls for a positive relationship between interest rates and
the volume of savings.
 Higher interest rates bring forth a greater volume of current savings.
 Saving by Business Firms
 Not only households but also businesses save.
 Most businesses hold savings balances in the form of retained earnings (as reflected in their
equity or net worth accounts).
 In fact, the increase in retained earnings reported by businesses each year is a key measure
of the volume of current business saving, which supplies most of the money for annual
investment spending by business firms.
 The critical element in determining the amount of business savings is the level of business
profits.
 If profits are expected to rise, businesses will be able to draw more heavily on earnings
retained in the firm and less heavily on the money capital markets for funds.
 The result is a reduction in the demand for credit and a tendency toward lower interest
rates.

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 On the other hand, when profits fall but firms do not cut back on their investment plans,
they will be forced to make the heavier use of the money and capital markets for investment
funds.
 The demand for credit rises, and interest rates may rise as well.
 Although the principal determinant of business saving is profits, interest rates also play a
role in the decision of what proportion of current operating costs and long-term investment
expenditures should be financed internally from retained earnings and what proportion
should be financed externally from borrowing in the money and capital markets.
 Higher interest rates in the money and capital markets typically encourage firms to use
internally generated funds more heavily in financing their projects.
 Conversely (in the other hand), lower interest rates encourage greater use of external funds
from the money and capital markets.
 Saving by Government
 Governments also save, though usually less frequently than households and businesses.
 In fact, most government saving (i.e., a budget surplus) appears to be unintended
(unplanned) saving that arises when government receipts unexpectedly exceed the actual
amount of expenditures.
 Income flows in the economy (out of which government tax revenues arise) and the pacing
of government spending programs are the dominant factors affecting government savings.
 However, interest rates can play a role in that higher interest rates raise interest payments
owed on the government’s debt. These higher expenditures tend to increase government
deficits (reduce budget surpluses), and, thereby, reduce government savings.
 The Demand for Investment Funds

Business, household, and government savings are important determinants of interest rates
according to the classical theory of interest, but they are not the only ones. The other critical rate-
determining factor is investment spending, most of it carried out by business firms.
Certainly, businesses, as the leading investment sector in the economy, require huge amount of
funds each year to purchase equipment, machinery, and inventories, and to support the
construction of new buildings and other physical facilities. The majority of business expenditure

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for these purposes consists of replacement investment; that is, expenditures to replace equipment
and facilities that are wearing out or are technologically obsolete.
A smaller but more dynamic form of business capital spending is labeled net investment:
expenditures to acquire new equipment and facilities in order to increase output. The sum of
replacement investment plus net investment equals gross investment.
Limitations of the Classical Theory of Interest
The classical theory of interest sheds (get rid of) light on the factors affecting interest rates.
However, it has limitations. The central problem is that the theory ignores factors other than saving
and investment that affect interest rates. For example, many financial institutions have the power
to create money today by making loans to the public. When borrowers repay their loans, money is
destroyed. The volume of money created or destroyed affects the total amount of credit available
in the financial system and, therefore; must be considered in any explanation of interest rates. In
addition, the classical theory assumes that interest rates are the principal determinant of the
quantity of savings available. Today economists recognize that income and wealth are probably
more important in determining the volume of saving. Finally, the classical theory contends (run)
that the demand for borrowed funds comes principally from the business sector. Today, however;
both consumers and government are also important borrowers.

2. The Keynes’s Liquidity Preference or Cash Balances Theory of Interest Rates

According to Keynes, Interest is purely a monetary phenomenon. It is the reward of not hoarding
but the reward for parting with liquidity for the specified period. It is not the ‘Price’, which brings
into equilibrium the demand for resources to invest with the readiness to abstain from
consumption. It is the ‘Price’ which equilibrates the desire to hold wealth in the form of cash with
the available quantity of cash.

Here Liquidity Preference Theory is determined by the supply of and demand for money. Supply
of money comes from banks and the government. On the other hand, demand for money is the
preference for liquidity. According to Keynes people like to hoard money because it possesses
liquidity.

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Hence, when somebody lends money he has to sacrifice this liquidity. A reward which is offered
to make him prepared for parting with liquidity is called Interest. Therefore, in the eyes of
Keynes—”Interest is the reward for parting with liquidity for a specific period.”

 The Demand for Liquidity

The liquidity preference theory contends that the rate of interest is really a payment for the use of
a scarce resource-money (cash balances). Businesses and individuals prefer to hold money for
carrying out daily transactions and also as a precaution against future cash needs even though
money’s yield is usually low or even nonexistent. Investors in fixed-income securities, such as
government bonds, frequently desire to hold money or cash balances as a haven against declining
asset prices. Interest rates, therefore; are the price that must be paid to induce money holders to
surrender a perfectly liquid asset (cash balances) and hold other assets that carry more risk. At
times the preference for liquidity grows very strong. Unless the money supply is expanded, interest
rates will rise.
In the theory of liquidity preference, only two outlets for investor funds are considered: bonds and
money or cash balances (including bank deposits). Money provides perfect liquidity (instant
spending power). Bonds pay interest but cannot be spent until converted into cash. If interest rates
raise, the market value of bonds paying a fixed rate of interest falls; the investor would suffer a
capital if those bonds were converted into cash. On the other hand, a fall in interest rates results in
higher bond prices; the bondholder will experience a capital gain if his/her bonds are sold for cash.
To the classical theorists, it was irrational to hold money because it provided little or no return. To
proponents of liquidity preference, however; the holding of money (cash balances) could be a
perfectly rational act if interest rates were expected to rise, because rising rates can result in
substantial losses for investors in bonds.

 Motives for Holding Money (Cash Balances)

According to liquidity preference theory, the public demands money for three different purposes
(motives).
i. Transaction motive: represents the demand for money (cash balances) to purchase goods
and services. Because inflows and outflows of money are not perfectly synchronized in
either timing or amount and because it is costly to shift back and forth between money
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and other assets, businesses, households, and governments must keep some cash in the till
or in demand accounts simply to meet daily expenses.
ii. Precautionary motive: Some money also must be held as a reserve for future emergencies
and to cover extraordinary expenses. This precautionary motive arises because we live in
a world of uncertainty and cannot predict exactly what expenses or investment
opportunities will arise in the future.
iii. Speculative motive: this stems from uncertainty about the future prices of bonds. If
investors expect rising interest rates, many of them will demand money or near –money
assets (such as deposits in a bank, credit union, or money market fund) instead of bonds
because they believe bond prices will fall. As the expectation that interest rates will rise
grows strong in the market place, the demand for cash balances as a secure store of value
increases.

 Total Demand for Money (Cash Balances)

The total demand for money or cash balances in the economy is simply the sum of transactions,
precautionary, and speculative demands. Because the principal determinant of transactions and
precautionary demand is income, not interest rates, these money demands are fixed at a certain
level of national income.

 The Supply of Money (Cash Balances)

The other major element determining interest rates in liquidity preference theory is the supply of
money. In modern economies, the money supply is controlled, or at least closely regulated, by
government. Because government decisions concerning the size of the money supply presumably
are guided by the public welfare, not by the level of interest rates, we assume that the supply of
cash balances is inelastic with respect to the rate of interest.
Limitations of the Liquidity Preference Theory
It is a short-term approach to interest rate determination unless modified because it assumes that
income remains stable. In the longer term, interest rates are affected by changes in the level of
income and by inflationary expectations. Indeed, it is impossible to have a stable equilibrium
interest rate without also reaching an equilibrium level of income, saving, and investment in the

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economy. Also, liquidity preference considers only the supply and demand for the stock of money,
whereas business, consumer, and government demands for credit clearly have an impact on the
cost of credit. A more comprehensive view of interest rates is needed that considers the important
roles played by all actors in the financial system: businesses, households, and governments.

3. The Loanable Funds Theory of Interest

A view that overcomes many of the limitations of earlier theories is the loanable funds theory of
interest rate. It is the most popular interest rate theory among practitioners and those who follow
interest rates “on the street.”

The loanable funds view argues that the risk-free interest rate is determined by the interplay of two
forces: the demand for and supply of credit (loanable funds). The demand for loanable funds
consists of credit demands from domestic businesses, consumers, and governments, and also
borrowing in the domestic market by foreigners. The supply of loanable funds stems from domestic
savings, dishoarding of money balances, money creation by the banking system, and lending in
the domestic market by foreign individuals and institutions.

NOTE: According to this theory:

 Total demand for loanable funds = DD by consumers + DD by business + DD by

government + DD by foreign (where; DD = Demand)
 Total supply of loanable funds = Domestic savings + newly created money + Foreign
lending to domestic credit markets – Hoarding DD for cash balances. …. (DD =
Demand)
4. The Rational Expectations Theory of Interest

This theory builds on a growing body of research evidence that the money and capital markets are
highly efficient institutions in digesting new information affecting interest rates and security
prices. For example, when new information appears about investment, saving or the money supply,
investors begin immediately to translate that new information into decisions to borrow or lend
funds. So rapid is this process of the market digesting new information that asset prices and interest
rates presumably incorporate the new data from virtually the moment they appear. In a perfectly

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efficient market, it is impossible to win excess returns consistently by trading on publicly available
information.
This expectation theory assumes that businesses and individuals are rational agents who attempt
to make optimal use of the resources at their disposal in order to maximize their returns. Moreover,
a rational agent will tend to make unbiased forecasts of future asset prices, interest rates, and other
variables. That is, he or she will make no systematic forecasting errors and will easily spot past
patterns in forecast errors and correct them quickly.
If the money and capital markets are highly efficient, this implies that interest rates always be very
near their equilibrium levels. Any deviation from the equilibrium interest rate dictated by demand
and supply forces will almost instantly eliminated. Security traders who hope to consistently earn
windfall profits from correctly guessing whether interest rates are ‘’too high’’ (and therefore will
probably fall) or “too low” (and therefore will probably rise) are unlikely to be successful in the
long term. Interest rate fluctuations around equilibrium are likely to be random and rapid.
Moreover, knowledge of past interest rates-for example, those that prevailed yesterday or last
month – will not be a reliable forecast of where those rates are likely to be in the future. Indeed,
the rational expectation theory suggests that in the absence of new information, the optimal
forecast of next period’s interest rate would probably be equal to the current period’s interest rate.
This is because there is no particular reason for the next period’s interest rate to be either higher
or lower than today’s interest rate until new information causes market participants to revise their
expectations.
Old news will not affect today’s interest rates because those rates already have impounded the old
news. Interest rates will change only if entirely new and unexpected information appears. For
example, if the federal government announces for several weeks running that it must borrow an
additional $10 billion next month, interest rates probably reacted to that information the first time
it appeared. In fact, interest rates probably increased at that time, because many investors would
view the government’s additional need for credit as adding to other demands for credit in the
economy and, with the supply of funds unchanged, interest rates would be expected to rise.
However, if the government merely repeated that same announcement again, interest rates
probably would not change a second time, it would be old information already reflected in today’s
interest rates.

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3.3. Factors affecting structure of interest rate determinations

The term structure of interest rates is the relationship between interest rates or bond yields and
different terms or maturities. The term structure of interest rates is also known as a yield curve
and it plays a central role in an economy. The term structure reflects expectations of market
participants about future changes in interest rates and their assessment of monetary policy
conditions. There are 3 factors that affect the structure of interest rate determination. Those
are:

1. Default risk: One attribute of bond that influences its interest rates is default risk. It
occurs when the issuer of bond is unable or unwilling to make interest payments when
promised or pay off the face value when the bond is mature. The spread between the
interest rate on one bond with default risk and default free bond with the same maturity
is called risk premium. A bond with default risk will always have positive risk premium
and increases its risk premium with increase of bond default.
2. Liquidity: Another factor that affects the interest rates is its liquidity. The bonds with
guaranty of more liquidity will be more desirable by the public. Because, early
conversion is safe of cash but, less of interest rates; more desirable will have demand
which in turn leads to less rate of interest. For instance, government bonds like treasury
bond (TB) are more liquid and have less interest rate (Because of conversion requires
less time, low transaction cost and it is tax-free). The reverse is true for corporation
bonds.
3. Income tax: Tax imposed also count the calculation of interest rates of a bond.
Example: municipality bonds are default free risk and tax free. But, they are with less
interest rate. On the other hand, corporation bonds are with high interest rate. But public
prefer to invest in municipality bonds as they are tax-free.

3.4. Estimating Nominal Interest Rate

A nominal interest rate is the theoretical or stated interest rate on an investment, usually
expressed as a percentage of the principal amount. The nominal interest rate does not take into
account inflation and other factors that will erode the purchasing power of the investment over
time.

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The nominal interest rate is the starting point for most investment decisions and analyses. Investors
look at the possible gains against their risk profile, calculate a required return based on that
information, and then compare it to available investments.

Nominal interest rates can be impacted by different factors, including the demand and bank, and
many others. Central banks implement the short-term nominal interest rate as a tool of monetary
policy.
During an economic recession, the nominal rate is lowered to stimulate economic activities. During
inflationary periods, the nominal rate is raised.

How to Calculate the Nominal Interest Rate?

There is not one single formula used for determining what an individual or company's Nominal
Interest Rate is.

One can calculate a nominal interest rate by using this equation:

For example, if someone is looking to invest $100 with an annual interest rate of 12%, they would
calculate the nominal interest rate as follows:

(𝑃 𝑥 𝐴𝑃𝑅)
NIR = = (100 x 0.12)/100 = 0.12 = 12%
100

Difference between Nominal Interest Rate and Real Interest Rate

The real interest rate takes into account inflation or deflation of purchasing power over time (the
price level) whereas the Nominal Interest Rate does not factor this in.

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The Fisher Effect

Well-known economist Irving Fisher coined the Fisher Effect, which is a theory that describes
the relationship between nominal and real interest rates. It states that the real interest rate of a
savings account is actually the difference between the nominal interest rate and the expected
inflation rate.

------------------- CHAPTER ENDED ------------------

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