Chapter 05 - The Determinants of Interest Rates: Competing Ideas

Chapter 5
The Determinants of Interest Rates:
Competing Ideas

Learning Objectives
You will see the important roles that interest rates play within the economy.
You will explore the most important ideas about what determines the level of
interest rates and asset prices within the financial system.
You will learn what economists believe are the key forces that set market
interest rates and asset prices in motion.

Key Topics Outline

Interest Rate: Nature and Roles within the Financial System.
The Classical Theory of Interest: Assumptions and Conclusions.
The Substitution Effect and Investment Demand.
Liquidity Preference Theory: Demand and Supply of Cash Balances.
Central Banking and Interest Rates.
The Credit Theory of Interest Rates: Demand and Supply of Loanable Funds.
Rational Expectations and the Publics Changing Outlook for Interest Rates.

Chapter Outline
5.1. Introduction: Interest Rates and the Prices of Credit
5.2. Functions of the Rate of Interest in the Economy
5.3. The Classical Theory of Interest Rates
5.3.1. Saving by Households
5.3.2. Saving by Business Firms
5.3.3. Saving by Government
5.3.4. The Demand for Investment Funds
5.3.4.1. The Investment Decision-Making Process
5.3.4.2. Investment Demand and the Rate of Interest
5.3.5. The Equilibrium Rate of Interest in the Classical Theory of Interest
5.3.6. Limitations of the Classical Theory of Interest
5.4. The Liquidity Preference or Cash Balances Theory of Interest Rates
5.4.1. The Demand for Liquidity
5.4.1.1. Motives for Holding Money (Cash Balances)
5.4.1.2. Total Demand for Money (Cash Balances)
5.4.2. The Supply of Money (Cash Balances)
5.4.3. The Equilibrium Rate of Interest in Liquidity Preference Theory
5.4.4. Limitations of the Liquidity Preference Theory
5.5. The Loanable Funds Theory of Interest
5.5.1. The Demand for Loanable Funds
5.5.1.1. Consumers (Household) Demand for Loanable Funds
5.5.1.2. Domestic Business Demand for Loanable Funds

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5.5.1.3. Government Demand for Loanable Funds

5.5.1.4. Foreign Demand for Loanable Funds
5.5.2. Total Demand for Loanable Funds
5.5.3. The Supply of Loanable Funds
5.5.3.1. Domestic Saving
5.5.3.2. Dishoarding of Money Balances
5.5.3.3. Creation of Credit by the Domestic Banking System
5.5.3.4. Foreign Lending to the Domestic Funds Market
5.5.4. Total Supply of Loanable Funds
5.5.5. The Equilibrium Rate of Interest in the Loanable Funds Theory
5.6. The Rational Expectations Theory of Interest

Key Terms Appearing in This Chapter

rate of interest, 119 loanable funds theory of interest rates,
132
price of credit, 119
income effect, 133
risk-free rate of interest, 120
wealth effect, 121
classical theory of interest rates, 120
rational expectations theory of interest
substitution effect, 121
rates, 137
liquidity preference theory of interest
rates, 126

Questions to Help You Study

1. What are the functions or roles played by the rate of interest in the economy
and financial system? Can you explain why each function is important to the
well-being of individuals, businesses, and governments?
Answer: The rate of interest performs several important functions in the economy:
a. It helps guarantee that current savings will flow into investment to promote
economic growth. Economic growth will create new jobs, boost business
revenue and capital expenditure, and increase governments' tax revenue.
b. It rations the availability supply of credit, generally providing loanable funds
to those investment projects with the highest expected return.
c. It brings the supply of money into balance with the public's demand for
money. This adjustment feature is critical in promoting the welfare of all
parties since once the equilibrium interest rate (price of borrowing) is set, the
cost of capital is fairly determined by the market mechanism and borrowing
and lending events are facilitated. When money transfers from the depositors
(like you and me) to the borrowers (like corporations), businesses will make
good use of the capital to create economic value and the whole economy will
benefit from such an effort.

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d. It is an important tool of government policy through its influence on the

volume of saving and investment. If the economy is growing too slowly and
unemployment rate is rising, the government can use its policy tools to lower
interest rates in order to stimulate borrowing and investment. On the other
hand, an economy experiencing rapid inflation has traditionally called for a
government policy of higher interest rates to slow borrowing and spending and
encourage more saving.
2. Explain the meaning of the term pure or risk-free rate of interest? Why is this
interest rate important and what is its relationship to other interest rates?
Answer: Pure or risk-free rate of interest is one fundamental interest rate by our
assumption. The pure or risk-free rate of interest is a component of all interest rates.
While the pure or risk-free rate of interest exists only in theory, the closest real-world
approximation to this pure rate of return is the market interest rate on government
bonds. It is a rate of return presenting little or no risk of financial loss to the investor
and representing the opportunity cost of holding idle cash because the investor can
always invest in government bonds of the lowest risk and earn this minimum rate of
return.

3. If we could identify the forces shaping the risk-free or pure rate of interest,
what advantage could this give us explaining the many different interest rates we
see every day in the real world?
Answer: The knowledge of the forces that shape the level of and changes in the risk-
free or pure rate of interest will help us forecast the new risk-free or pure rate of
interest and other market interest rates and the speed with which these rates move to
the levels. For example, the classical theory of interest rates helps us to understand
some of the long-term forces driving interest rates. Based on such theory, several
economists have argued that, in the future, interest rates may average lower than
today's interest rates. This may be true because the populations of the United States
and most other nations are aging, shifting heavily toward age groups in which
individuals spend less of their current income and save more (in part to prepare for
retirement).

4. In the classical theory of interest rates, what forces determine the market rate
of interest? What assumptions does the classical theory of interest rest upon?
Answer: In the Classical theory of interest rates, the major forces that determine the
market rate of interest are the demand for investment and the volume of saving.
Limitations/Assumptions of the Classical theory of interest include the ignoring of
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. The
Classical theory of interest also assumes that interest rates are the principal
determinant of the quantity of savings available. However, economists recognize
today that income is actually more important in determining the volume of saving.

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5. Explain why the supply curve in the classical theory of interest rates has a
positive slope. Why does the demand curve in the classical theory have a negative
slope?
Answer: The supply curve in the Classical theory of interest rates has a positive slope
because the so-called substitution effect mandates that "higher interest rates increase
the attractiveness of saving relative to consumption spending, encouraging more
individuals to substitute current consumption (and future consumption) for some
quantity of current saving." The demand curve in the Classical theory has a negative
slope partly because "at lower rates of interest, more investment projects become
economically viable and firms require more funds to finance a longer list of projects."

6. What are the origins of the liquidity preference theory of interest? What
assumptions underlie this important idea about what determines market rates of
interest?
Answer: The classical theory of interest has been called a long-term explanation of
interest rates because it focuses on the public's thrift habits and the productivity of
capital-factors that tend to change slowly. During the 1930s, British economist John
Maynard Keynes (1936) developed a short-term theory of the rate of interest that, he
argued, was more relevant for policy makers and for explaining near-term changes in
interest rates. This theory is known as the liquidity preference (or cash balances)
theory of interest rates. Like the classical theory of interest, liquidity preference
theory has assumptions/limitations. 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 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 that considers the important roles played by all actors in the financial system
(i.e., businesses, households, and governments) is needed.

7. The demand for money is a critical element in the liquidity preference theory
of interest. What are the three main components of the demand for money?
Answer: There are three different purposes (motives) of the demand for money:
The transactions motive represents the demand for money (cash balances) to
purchase goods and services. The precautionary motive arises because we live in an
uncertain world and cannot predict exactly what our expenditures, or perhaps even our
income, will be in the future. The speculative motive stems from uncertainty about the
future prices of bonds. When there is greater uncertainty about future bond prices, the
risk of capital loss resulting from falling bond prices will cause many investors to
demand money or near-money assets instead of bonds.

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8. What factors appear to determine the transactions demand for money? How
about the precautionary motive for demanding and holding money? The
speculative motive?
Answer: The transactions demand for money was assumed to be dependent on the
level of national income, business sales, and prices. Reflecting moneys role as a
medium of exchange, higher levels of income, sales, or prices increase the need for
cash balances to carry out transactions. For the precautionary demand for money,
increases in times of greater economic uncertainty will increase the precautionary
demand for money too. For speculative motive, when there is greater uncertainty
about future bond prices, the risk of capital loss resulting from falling bond prices will
cause many investors to demand money or near-money assets instead of bonds.

9. What makes up the total demand for money? What is the shape of the
relationship between the total demand for money and the market rate of
interest?
Answer: The total demand for money is made up of transactions, precautionary, and
speculative demands. Transactions demand is tied to the level of income (spending)
in the economy. Precautionary demand is tied to income uncertainty, while speculative
demands for money are related to expectations of changes in interest rates. If
investors expect rising interest rates, many of them will demand money or near-
money assets instead of bonds because they believe bond prices will fall. As the
expectation that interest rates will rise grows strong in the marketplace, the demand
for cash balances as a secure store of value increases. We may represent this
speculative demand for money by a line or curve that slopes downward and to the
right, reflecting a negative relationship between the speculative demand for money
and the level of interest rates.

10. What determines the equilibrium interest rate under the liquidity preference
theory of interest? What forces cause the equilibrium interest rate to move?
Answer: The interplay of the total demand for and the supply of money or cash
balances determine the equilibrium rate of interest in the short run. Please refer to
Exhibit 5-4 to see what the equilibrium interest rate looks like under the Liquidity
Preference Theory of Interest. As shown in Exhibit 5.4, the equilibrium rate is found
at point iE, where the quantity of money demanded by the public equals the quantity of
money supplied. Above this equilibrium rate, the supply of money exceeds the
quantity demanded, and some businesses, households, and units of government will
try to dispose of their unwanted cash balances by purchasing bonds. The prices of
bonds will rise, driving interest rates down toward equilibrium at iE. On the other
hand, at rates below equilibrium, the quantity of money demanded exceeds the supply.
Some decision makers in the economy will sell their bonds to raise additional cash,
driving bond prices down and interest rates up toward equilibrium.

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11. What are the principal limitations of the liquidity preference theory of
interest?

Answer: The liquidity preference theory is a short-term approach to interest rate

determination that fails to capture the fact that over 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 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.

12. What are loanable funds? Why is this term important?

Answer: 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 four sources: domestic savings,
dishoarding of money balances, money creation by the banking system, and lending in
the domestic market by foreign individuals and institutions. The importance of the
loanable funds theory of interest rates resides in the fact that it is the most popular
interest-rate theory among practitioners and those who follow interest rates on the
street.

13. What factors make up the total demand for loanable funds? The total supply
of loanable funds? List and define each of these demand and supply factors.
Answer: he total demand for loanable funds comes from the sum of consumer,
business, and government demand for credit. Sources of loanable funds include saving
by businesses, consumers and governments, dishoarding of money balances, and
money created by the banking system. The interest rate tends toward the point where
the supply of loanable funds equals the demand for loanable funds.

14. Explain how the equilibrium loanable funds interest rate is determined. Draw
a graph to illustrate what the equilibrium rate of interest might look like.
Answer: The two forces of supply and demand for loanable funds determine not only
the volume of lending and borrowing but also the rate of interest. The interest rate
tends toward the equilibrium point at which the supply of loanable funds equals the
demand for loanable funds. This point of equilibrium is shown in Exhibit 5.5 at iE.
Please refer to Exhibit 5.5 in the text for a graph of the equilibrium rate of interest
under the Loanable Funds theory.

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15. Suppose the demand for loanable funds increases relative to the supply. What
happens to the equilibrium rate of interest? Suppose, on the other hand, the
supply of loanable funds expands with loanable funds demand unchanged. What
does the equilibrium loanable funds interest rate look like under these
circumstances?

Answer: If demand increases with supply unchanged, the volume of loans will
increase but those loans will be made at higher rates of interest as demand pressure
forces rates upward. Please refer to Exhibit 5.6(B) in the text to see a picture of the
changes in the equilibrium interest rates.
An increase in loanable-funds supply without an increase in demand will make
more loanable funds available and interest rates will tend to decline. Please refer to
Exhibit 5.6(A) in the text to see a picture of the changes in the equilibrium interest
rates.

16. What does it take to have a permanently stable equilibrium interest rate under
the loanable funds theory of interest? How does this differ from a temporary or
partial equilibrium loanable funds rate?
Answer: The equilibrium depicted in Exhibit 5.5 is only a partial equilibrium
position, however.
This is due to the fact that interest rates are affected by conditions in both the
domestic and world economies. For the economy to be in equilibrium, planned saving
must equal planned investment across the whole economic system. For example, if
planned investment exceeds planned saving at the equilibrium interest rate shown in
Exhibit 5-5, investment demands will push interest rates higher in the short term.
However, as additional investment spending occurs, incomes will rise, generating a
greater volume of savings. Eventually, interest rates will fall. Similarly, if exchange
rates between dollars, yen, and other world currencies are not in equilibrium with each
other, there will be further opportunities for profit available to foreign and domestic
lenders by moving loanable funds from one country to another. Only when the
economy, the money market, the loanable funds market, and foreign currency markets
are simultaneously in equilibrium will interest rates remain stable. Thus a stable
equilibrium interest rate over the long run will be characterized by the following set of
circumstances:
1. Planned saving = Planned investment (including business, household, and
government investment) across the whole economic system (i.e., equilibrium
in the economy).
2. Money supply = Money demand (i.e., equilibrium in the money market).
3. Quantity of loanable funds supplied = Quantity of loanable funds
demanded (i.e., equilibrium in the loanable funds market).
4. The difference between foreign demand for loanable funds and the volume
of loanable funds supplied by foreigners to the domestic economy = The
difference between current exports from and imports into the domestic
economy (i.e., equilibrium in the balance of payments and foreign currency
markets).

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17. Can you explain what is meant by rational expectations?

Answer: The rational expectations are the theory that assumes businesses and
individuals attempt to make optimal use of the resources at their disposal in order to
maximize their returns. Investors begin immediately to translate that new information
into decisions to borrow or lend funds, when new information appears about
investment, saving, or the money supply.

18. What, then, is the rational expectations theory of interest rates? How does it
differ from the other interest-rate determination theories, discussed in this
chapter?
Answer: The Rational Expectations Theory of Interest focuses upon the total
expected supply of credit relative to the expected demand for credit. Rational
expectations assume the financial markets are so efficient that all available
information relevant to the prices of securities and interest rates is already reflected in
those prices and rates. Assuming investors are rational and, therefore, use all
available information to maximize their returns, security prices and rates will only
change if new information appears. Forecasting of interest rates is especially difficult
because the forecaster must know what the market expects to begin with and then
anticipate the impact of new information. Consistent windfall profits are impossible
and future changes in security prices and rates are not correlated with their past levels
or changes.

19. What assumptions underlie the rational expectations view of interest?

Answer: This view of interest rates and asset prices assumes that the money and
capital markets are highly efficient in the use of information in determining the
publics expectations regarding future changes in interest rates and asset prices.
Equilibrium interest rates impound all relevant information very quickly and change
only when relevant new information appears. Forecasting market interest rates is
presumed to be virtually impossible on a consistent basis because interest-rate
forecasters must know (1) what market participants expect to happen, and (2) what
new information will arrive in the market before that information actually arrives.

20. What are the implications of the rational expectations theory for those who
try to forecast changes in market rates of interest? Based on this view of interest
rates what would you recommend to interest-rate forecasters?
Answer: Under the rational expectations theory of interest, forecasting market interest
rates is presumed to be virtually impossible on a consistent basis because interest-rate
forecasters must know (1) what market participants expect to happen, and (2) what
new information will arrive in the market before that information actually arrives.
Although rationally informed expectations appear to exist in large auction
markets (such as the markets for government securities or for listed common stock), it
is not clear that such is the case for other financial markets, such as those for
consumer loans. Thus, not all interest rates and security prices appear to display the
kind of behavior implied by the rational expectations theory.

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Problems and Issues

1. The economy moves through business cycles, with periodic expansions, when
economic activity is higher than average, and economic slow-downs, which, if
severe enough, can lead to a recession. During expansion periods the volume
of loanable funds available from the financial system tends to increase and
real interest rates tend to rise. With this information in mind, explain the
following:
a. Why does the demand for loanable funds tend to increase during
expansions?
b. Why does the supply of loanable funds tend to increase during
expansions?
c. Does the supply of loanable funds tend to increase by more or less than the
demand for loanable funds during economic expansions? How do you
know?
ANSWER:
a. When the economy is expanding, there are plenty of great opportunities for
investing and the demand for loanable funds tends to increase.
b. When the demand for loanable funds is strong, the equilibrium interest rate is
higher and that will induce the increase of the supply of loanable funds. The
ability to increase the supply of loanable funds during expansions is enhanced
by the increase in economic activity that raises income for households, and a
portion of that additional income is saved and added to the pool of loanable
funds in the economy.
c. The increase of the demand for loanable funds will probably be higher than
that of the supply if the expansion is really significant. Evidence of this effect
is the fact that interest rates tend rise during periods of economic expansion
and fall during periods of economic weakness.

2. Construct a supply of savings schedule (with all schedules and axes correctly
labeled) that illustrates the income effect. Do the same to illustrate the wealth
and substitution effects. Explain the differences you observe.
ANSWER: For the income effect, higher interest rates allow the saver to save less as
rates go up because rising rates allow the saver to reach his or her total savings goal
faster. However, there is an opposite effect for many households who do not like to
change their expenditures on consumption goods and services abruptly. For them, an
increase in income would be absorbed to a large extent by increases in savings, with a
much more muted consumption response.
The wealth effect differs depending upon whether the saver is a net lender
(whose financial assets exceed his or her liabilities) or a net borrower (whose
outstanding liabilities exceed holdings of financial assets). For a net lender with
substantial accumulated wealth rising interest rates reduce the value of the wealth,
causing acceleration in savings activity. A net debtor, on the other hand, would save
less with rising rates.

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The substitution effect indicates that the household may choose to substitution
current consumption for higher future consumption by increasing their current savings
as interest rates increase.
3. Suppose the going market rate of interest on high-quality corporate bonds is
12 percent. FORTRAN Corporation is considering an investment project
which will last 10 years and requires an initial cash outlay of $1.5 million but
will generate estimated revenues of $500,000 per year for 10 years. Would
you recommend that this project be adopted? Explain why.
ANSWER: The internal rate of return on the proposed investment project by using
the formula on page 123 of the text. We have:
Cash outlay of $1.5 million = $0.5 mill. + $0.5 mill. + --- + $0.5 mill.
(1+y) (1+y)2 (1+y)10
Solving for y gives approximately a 31 percent annual rate of return. Because
the cost of capital is far lower, the project should be adopted, ceteris paribus.

4. The statements listed below were gathered from recent issues of financial
news sheets. Read each statement carefully and then (a) identify which
theory or theories of interest rate determination are implicit in each
statement and (b) indicate which direction interest rates should move if the
statement is correct analysis of the current market situation. Use appropriate
supply-demand diagrams, where possible, to show the reasoning behind your
answers to part (b).
a. The factor which is likely to dominate interest rate changes in the weeks
ahead is a tighter credit policy at the Federal Reserve.
b. The White House unexpectedly disclosed today that budget negotiations
with Capitol Hill have broken down. Market analysts are fearful of the
effects on the bond and stock markets when trading begins tomorrow
morning.
c. Corporate profits have declined significantly in the quarter just
concluded, following a year of substantial growth. Financial experts
expect this negative trend to continue for at least the next six months.
d. Personal consumption expenditures are rising rapidly, fueled by an
unprecedented level of borrowing. Personal savings are up in real dollar
terms, but the national savings rate dropped significantly this past year
and further declines are expected. Economists believe this recent change
in the savings rate explains the current trend in interest rates.
ANSWER:
a. Statement One - Liquidity Preference and Loanable Funds Theories. A tighter
credit policy implies slower money growth or actual contraction of the money
supply and rates of interest should rise.
b. Statement Two - Loanable Funds and Rational Expectations Theories. If the
market now expects more government borrowing, rates must rise. An
expectation of less government borrowing and interest rates should fall, ceteris
paribus.

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c. Statement Three - Classical Theory of Interest and Loanable Funds Theories.

Declining corporate profits could force corporations to borrow more to offset
declining profits. The extra demand for credit would push interest rates
higher. On the other hand, if corporations cut back on their investment plans,
borrowing may decline and interest rates would fall, ceteris paribus.
d. Statement Four - Classical Theory of Interest and Loanable Funds Theory.
With a lower savings rate and rising consumption there will be upward
pressure on credit markets due to excess credit demands relative to the
available supply of savings. Interest rates will tend to rise.
For the supply-demand diagram, you can see pictures of the effects of increased
supply with demanded unchanged in Exhibit 5.6 (A) and the effects of increased
demand with supply unchanged in Exhibit 5.6 (B).

5. Suppose that total savings and business investment demand in the economy
behaves as shown in the table that follows (dollars are in billions):

Total Investment Volume of Total Alternative Market

Demand for Funds Saving Expected Interest Rates
$170 $80 5%
$155 $96 6%
$142 $103 7%
$135 $135 8%
$128 $178 9%
$111 $207 10%
$92 $249 11%
$86 $285 12%

According to the classical theory of interest, what equilibrium interest rate

will prevail given the above schedules of planned saving and investment?
What could cause the equilibrium rate to change?
ANSWER: According to the Classical theory of interest, equilibrium is the point
where total business investment demand equals volume of total savings expected. We
can see that total investment demand equals total expected savings at $135 billion. At
this point, the market interest rate is 8%. The market rate will change if there is any
change in the business investment demand schedule or in the savings schedule or
both.

6. Suppose the total demand for money is described by the following equation:
MD 30 2i
where i is the prevailing market interest rate. The total supply of money is
described by the equation:
MS 3 7i
According to liquidity preference what is the equilibrium interest rate?

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ANSWER: The equilibrium interest rate is interest rate that the total demand equal to
the total supply of money that is:
MD 30 2i 3 7i MS
Hence the equilibrium rate equal to 27 9i that is i 3% . At a 3 percent market rate of
interest money demand equals money supply and the interest rate will be in
equilibrium.

EXCEL 7. A firm is considering the adoption of a project that is expected to generate

revenues for 10 years. These expected revenues (in dollars) are:

Year 1: 200,000 Year 6: 270,000

Year 2: 250,000 Year 7: 255,000
Year 3: 300,000 Year 8: 240,000
Year 4: 300,000 Year 9: 150,000
Year 5: 280,000 Year 10: 75,000

The total cost of the project, that is to be paid immediately upon adoption, is
$1.6 million. Use a spreadsheet to compute the Net Present Value of the
project if:
a. the firms cost of capital is 6 percent. Should the project be adopted?
b. the firms cost of capital is 8 percent. Should the project be adopted?
Suppose the firm has a second project that requires an initial outlay of
$800,000 and is expected to generate revenues for only 5 years, and those
revenues are of the same amounts as given above for years 1 to 5. Use the
same spreadsheet to compute the Net Present Value of this project if:
c. the firms cost of capital is 6 percent. Is this project one the firm would
like to adopt?
If these are the only two projects that the firm is contemplating, what should
the firm so if:
d. its capital budget is $1 million and its cost of capital is 6 percent?
e. its capital budget is $3 million and its cost of capital is 6 percent?
ANSWER:
a) Yes, the firm should adopt the project, because the Net Value of the project is
$1,751,096.78 that is greater than $1.6 millions.
Year Net Cash Flow Present Value
Year 1: 200,000 188,679.25
Year 2: 250,000 222,499.11
Year 3: 300,000 251,885.78
Year 4: 300,000 237,628.10
Year 5: 280,000 209,232.29
Year 6: 270,000 190,339.35
Year 7: 255,000 169,589.56
Year 8: 240,000 150,578.97
Year 9: 150,000 88,784.77
Year 10: 75,000 41,879.61
Total Present Value 1,751,096.78

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b) Yes, the firm should adopt the project, because the Net Value of the project is
$1,607,119.05 that is greater than $1.6 millions.
Year Net Cash Flow Present Value
Year 1: 200,000 185,185.19
Year 2: 250,000 214,334.71
Year 3: 300,000 238,149.67
Year 4: 300,000 220,508.96
Year 5: 280,000 190,563.30
Year 6: 270,000 170,145.80
Year 7: 255,000 148,790.05
Year 8: 240,000 129,664.53
Year 9: 150,000 75,037.35
Year 10: 75,000 34,739.51
Total Present Value 1,607,119.05

c) Yes, the firm should adopt the project, because the Net Value of the second project
is $1,109,924.53 that is greater than $800,000.
Year Net Cash Flow Present Value
Year 1: 200,000 188,679.25
Year 2: 250,000 222,499.11
Year 3: 300,000 251,885.78
Year 4: 300,000 237,628.10
Year 5: 280,000 209,232.29
Total Present Value 1,109,924.53

d) If the firms capital budget is $1 million and its cost of capital is 6 percent, firm can
adopt just only the second project. The firm can gain from expected the present value
profit of the second project equal to $309,924.53 (from $1,109,924.53 $800,000).
e) If the firms capital budget is $3 million and its cost of capital is 6 percent, firm can
adopt both projects. The firm can gain from expected the present value profit of the
first project equal to $151,096.70 (from $1,751,096.70 - $1,600,000) and of the
second project equal to $309,924.53 (from $1,109,924.53 $800,000). The total
present value profit equal to $461,021.31 (from $151,096.70 + $309,924.53).

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Chapter 05 - The Determinants of Interest Rates: Competing Ideas

Web-Based Problems
1. Why do explanations of interest-rate movements differ among investment
professionals? Examine at least two of the most popular accounts of daily
interest-rate changes. (Examples include cnnfn.com and bondsonline.com.)
How does each source explain the most recent movements in market rates?
Why are there differences among experts about why interest rates are
changing?
Answer: Experts often have varying opinions regarding the driving force of market
rate changes. It is because they may have different sources of information, may
analyze news from different angles, or they may even hold different beliefs regarding
the driving force of the interest rate movement.

2. Financial institutions are the principal source of loanable funds in the

U.S. economy, with commercial banks accounting for the single largest share of
credit (loanable funds) creation in the financial system. This exercise asks you to
examine the amount of credit contributed to the economy by all commercial
banks.

Go to the website of the Federal Reserve: www.federalreserve.gov and click

on the listing on their home page: All Statistical Releases. Locate the
current H.8 Release entitled: Assets and Liabilities of Commercial Banks in
the U.S. The first page of this release is the consolidated balance sheet for
U.S. banks. Identify the amount of credit (loanable funds) created in the most
recent year, referred to as Bank Credit. How much credit is being created
by U.S. banks on a per capita basis? (It is easy to find the total U.S.
population on the internet.) What percentage of these banks total assets is
represented by bank credit? What are the major uses of this credit by bank
borrowers?
Answer: From http://www.federalreserve.gov/releases/h8/Current/: On June 27, 2007,
the amount of credit (loanable funds) created are $8,567.2 billions as Bank Credit.
From http://www.census.gov/population/www/popclockus.html: U.S. Census Bureau
on July 9, 2007, the total U.S. population is 302,299,197. Hence the credit that is
created by U.S. banks on a per capita equal to $28,340 ($8,567.2 billions /
302,299,197). The total assets are $10,025.1 billion, then the percentage of bank
credit is 85.46% ($8,567.2 / $10,025.1 * 100%). The major uses of this credit are
Loans and leases in bank credit that is $6,273.0 billions.

3. One source of credit in any economy is money created by the central bank.
This credit is often referred to as the monetary base or outside money,
referring to the fact it is created outside the private financial system. This
exercise asks you to compare the amount of credit created as outside money
by two of the worlds leading central banks: the Federal Reserve and the
Bank of English in the U.K.

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Chapter 05 - The Determinants of Interest Rates: Competing Ideas

Go to the each of the central bank website: www.federalreserve.gov and

www.bankofengland.co.uk and find the values of the monetary base. For the
U.S. this can be found in the H.3 Statistical Release. For the U.K. go to:
http://www.bankofengland.co.uk/statistics/ms/current/index.htm#a and look
under Table A1.1.1, page 2. The monetary base is the sum of Notes and coin
in circulation outside the Bank of England and Reserve Balances. Convert
this sum to U.S. dollars using the current dollar/pound exchange rate (which
is easily found on the internet.) Other information that you will need
includes: (i) The Gross Domestic Product (GDP) of the U.S. and U.K. Convert
the British GDP into dollars and (ii) The population of the U.S. and U.K.
(This information is very easy to find on the internet.)
To compare how much outside money is being provided in the two countries,
you need to compare the numbers with respect to the size of these two
economies. First, simply divide outside money in dollars by population to
determine the per capita amount in circulation. Which is larger? A second
useful comparison is to construct a measure called Velocity which is GDP
divided by the monetary base. This gives some sense of how many times each
dollars of outside money (on average) turns over through expenditures on
goods and services in a years time. Find the velocity of the monetary base for
both the U.S. and U.K. Which is larger? Is this consistent with the per capita
supplies of outside money in the two countries? Could the fact that a larger
portion of U.S. currency is held overseas versus U.K. currency held outside of
the U.K. help to account for these differences? Please explain.
Answer: For U.S. from http://www.federalreserve.gov/releases/h3/Current/: in June
2007, the Monetary Base equal to $819,118 millions. The exchange rate of the current
dollar/pound is $2.015 per pound on July 9, 2007. For the U.K. in May 2007 from
http://www.bankofengland.co.uk/statistics/ms/2007/Jun/tabA1.1.1.xls: the Monetary
Base is 54,587 millions of pound (Notes and coin in circulation outside the Bank of
England 47,044 millions and Reserve Balances 17,543 millions of pound) or
$109,992.8 millions.
The U.S. GDP in the first quarter of 2007 equal to $13,620.2 billions in current
dollars from http://www.bea.gov/national/xls/gdplev.xls.
The U.K. GDP in the first quarter of 2007 equal to 305,468 millions in pound
or $615,518.0 million from http://www.statistics.gov.uk/pdfdir/gdpbrief0407.pdf.
The total U.S. population is 302,299,197 by U.S. Census Bureau on July 9,
2007 (http://www.census.gov/population/www/popclockus.html).
The total U.K. population is 60,776,238 on July 2007 (estimation) from
https://www.cia.gov/library/publications/the-world-factbook/print/uk.html.
For comparison in the Monetary Base per capita, for U.S. the per capita
amount in circulation is $2,709.6 and $1,809.8 for U.K. Hence the U.S. is larger than
U.K. For the Velocity, the velocity of the monetary base is 16.63 for U.S. and 5.60 for
U.K. Hence the U.S. is larger in velocity of the monetary base than U.K.
Yes, this is consistent with the per capita supplies of outside money in the two
countries. The larger portion of U.S. currency is held overseas versus U.K. currency
held outside of the U.K. helps to account for these differences, since currency held
outside the domestic economy is not closely related to the economic activity of the
country (GDP).

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