Chapter 2

An Overview of the Financial System and Interest Rates

Financial system and its functions
• There are various ways to finance capital investments:
Using own past savings
Borrowing from other sources ( someone else’s savings)
• Financial system is a group of institutions that help to match
one person’s saving with another person’s investment.
• These institutions include;
1) Financial markets
2) Financial intermediaries
• These institutions have the basic function of moving funds
from people who have a surplus of funds to those who have
a shortage of funds.
Fig. Flows of funds through the financial system

Lenders/savers Borrowers/spenders
- Households - Households
- Business firms - Business firms
- Government - Government
- Foreigners - Foreigners
 Firms need funds to expand their business.
 Government needs funds to build infrastructure
services.
 Households and foreigners borrow to finance their
purchases (consumer durable goods).
• Saving and investment are key ingredients to long-run
economic growth.
 When a country saves a large portion of its GDP, more
resources are available for investment, so more capital
and more capital increases a country’s productivity and
living standard.
 Thus, well-functioning financial markets and financial
intermediaries are needed to improve economic
wellbeing and efficiency and are crucial to economic
health.
 Financial markets
• The pieces of paper being traded in financial markets are ==
securities ( financial instruments)
• Securities are claims on the borrower’s future income (such
as future dividends or future interest payments) or assets.
• Securities are:
- assets for the person who buys them.
- liabilities (debts) for the individual or firm that sells
(issues) them.
Functions of financial markets
 channel funds from people who have surplus funds (lenders)
to people who have a shortage of funds (borrowers).
Specifically,
1) provide funds for firm’s capital purchases
 To get the money to finance different forms of capital,
firms will issue long-term IOUs and exchange them for
the needed funds.
• This results in a long-lasting capital and a long-lasting
obligation to make future payments.
• The more capital a firm purchases, the greater the value
of the IOUs the firm will issue.
 There is connection between capital and financial
markets.
2) improve the well-being of consumers by allowing them
to time their purchases better.
3) provide funds to young people to buy what they need
now and pay later.
Structure of financial markets
There are different categories of financial markets:
 Debt and equity markets
 Primary and secondary markets
 Money and capital markets
Debt and equity markets
• A firm or an individual can obtain funds in a
financial market in two ways:
1) Issuing a debt instrument (bond and mortgage)
• Debt instrument is a contractual agreement by the
borrower to pay the holder of the instrument a
fixed amount of dollar (principal and interest
payments) at regular intervals until the maturity
date.
• A debt instrument may be:
 short-term : its maturity is less than a year
 intermediate-term: its maturity is between one and ten
years
 long-term: its maturity is ten years or longer
2) Issuing equities (common stock)
• Equities are claims to share net income (income after
expenses and taxes) and assets of a borrower.
• Equities are considered as long-term securities because
they have no maturity date.
• They usually make periodic payments (dividends) to
their holders.
• Dividends are part of a firm’s current profit that is
distributed to shareholders.
• A corporation must pay all its debt holders before it pays
its equity holders.
 An equity holder is a residual claimant.
• Equity holders benefit directly from any increases in the
corporation’s profitability or asset value because equities
confer ownership rights to the equity holders.
• Debt holders do not share from any increases in the
corporation’s profitability or asset value because their
dollar payments are fixed.
Primary and Secondary Markets
Primary market: the market in which newly issued securities
are sold for the first time.
• It is only in the primary market that the issuer of a security
obtains fund.
• The investment bank is an important financial institution
that assists the initial sale of securities in the primary
market.
Secondary market: the market in which previously issued
securities (and thus secondhand) are resold.
• In secondary market, the original issuing firm or
government agency is not involved, and acquires no new
funds.
• Brokers and dealers are crucial to the well-functioning of
secondary market.
 Brokers are agents of investors who match buyers with
sellers of securities.
 Dealers link buyers and sellers by buying and selling
securities at stated prices.
• Secondary markets serve two important functions:
1) they make the financial instruments more liquid.
2) they determine the price of the security that the issuing
firm sells in the primary market.
• Secondary markets can be organized in two ways:
1) Organized exchanges : buyers and sellers of securities
(or their agents or brokers) meet in one central location.
2) Over-the-counter (OTC) market: dealers at different
locations buy and sell securities "over the counter" to
anyone who comes to them and is willing to accept their
prices.
• Since over-the-counter dealers are in computer contact
and know the prices set by one another, the OTC market
is very competitive.
 Money and Capital Markets
• This is based is based on the maturity of the securities
traded in financial market.
1) Money market : only short-term debt instruments
(maturity of less than one year) are traded.
2) Capital market: longer-term debt instruments (maturity
of one year or greater) and equity instruments are traded.
Financial instruments
• The two most important financial instruments are bond
and stock.
A. Bond: is a promise by the borrower to pay a specific
sum of money, called principal or face value, at some
future date.
Principal (face value): is the amount of money a bond
promises to pay when it matures.
• It specifies the obligations of the borrower to the holder of
the bond.
 Bond is an IOU.
• It identifies date of maturity, and the rate of interest that will
be paid periodically until the bond matures.
Maturity date: is the date at which a bond’s principal
amount will be paid to the bond’s owner.
Bonds differ according to significant characteristics:
1) According to bond’s term--the length of time until the bond
matures.
- Short-term bonds
- Long-term bonds
• The British government has even issued a bond that
never matures, called perpetuity.
This bond pays interest forever, but the principal is
• The interest rate on a bond depends, in part, on its term.
 Long-term bonds usually pay higher interest rates than
short-term bonds. Why?
To compensate risk associated with long-term bonds
• Long-term bonds are riskier than short-term bonds because
holders of long-term bonds have to wait longer for
repayment of principal.
• If the holder of a long-term bond needs money before the
date of maturity, he/she has to sell the bond to someone else
at a reduced price.
2) According to the type of payment to be made on bond;
- Pure discount bonds--bond that promises no payments
except for the principal it pays at maturity.
- Bonds that promise coupon payments--series of periodic
payments that a bond promises before maturity.
3) According to bond’s credit risk--the probability that the
borrower will fail to pay some of the interest or principal.
- Default bonds—pay a higher interest rate
- Safe bonds(ex: gov’t bonds)– pay a lower interest rate
4) According to bond’s tax treatment-- the way the tax laws
treat the interest earned on the bond
- Bonds which are required to pay income tax on the interest
income
- Bonds which are not required to pay income tax on the
interest income
Valuing bond: involves present value, since bond is a promise
to pay a future payment.
I. PDB case: The of a PDB that promises to pay a
principal of when it matures in exactly years is:
Total

Ex: A pure discount bond that promises to pay $10,000

when it matures in exactly one year. Suppose the interest
rate at which you can borrow and lend funds is 10 %.

II. Case of bonds that promise coupon payments

• The of a bond maturing in years , and has a principal of
$, and promises a coupon payment of $ each year until
maturity, with the first payment made after one year from
today is calculated as :
Ex: Suppose a bond maturing in five years has a principal of
$10,000, and also promises a coupon payment of $600 each
year until maturity, with the first payment made after one
year from today. The total present value of this bond would
be:
Bond prices and bond yields

• There is an important relationship between the price of a

bond and its yield.
 A bond’s yield is rate of return that the bond earns for its
owner.
Ex: A pure discount bond that promises to pay $10,000
when it matures in exactly one year. Suppose you bought
this bond for $ 8,000.
At the end of the year, you would earn an interest of

 The bond’s yield would be or 25%
• But now suppose you bought this bond for $ 9,000.
 Your interest earnings would be

 The bond’s yield would be or 11.1%

 There is an inverse relationship between bond prices
and bond yields.
The higher the price of any given bond, the lower
the yield on that bond.
B. Stock
• A share of stock is a share of ownership in a firm.
• Like a bond, a share of stock is a financial asset that
promises its owner future payments.
• But the nature of the promise is very different for these
two types of assets.
 When a firm issues a bond, it is borrowing funds and
promising to pay them back.
 But when a firm issues a share of stock, it brings in
new ownership of the firm itself.
 Funds
Buyers of share Issuer of share
Entitlement of asset &
Share of profit
Why do people hold stock?
 When you buy a share of stock, you own part of the
firm
 Dividend. Firms pay out some of their profits to their
stockholders; this amount is called the dividend.
Profits not paid out are called retained earnings and are
used by the firm for additional investment.
 Capital gains==returns someone gets by selling a
financial asset at a price higher than they paid for it.
Ex: If you buy shares of AIB at $30 per share, and later sell
them at $35 per share, your capital gain is $5 per share.
Valuing a share of stock
• The value of a share of stock is the total present value of
its future payments.
• For a share of stock, the future payments are all the profits
that the share is expected to earn for its owner.
 But over what time horizon should stocks be valued?
• A share of stock has no maturity date and is expected to
remain an earning asset for its owners for as long as the
firm exists.
Simplest formula: If a firm will earn a constant $Y after-tax
profit each year forever, then the total present value of these
future profits is , where i is the discount rate.
Ex: If a firm is expected to earn $10 million after-tax profit
for its owners per year forever, and the discount rate is 10 %,
the total PV of those future profits is
 If there are 1 million shares of stock outstanding for this
firm, each share should be worth
• The value of a share of stock in a firm is equal to the total
present value of the firm’s after-tax profits, divided by the
number of shares outstanding.
Factors that can affect a stock’s value:
1) Firm’s current profit
• Earning forecasts are usually based on the firm’s current
earnings.
 An increase in current profits increases the value of a share of stock.
2) Anticipated growth rate of profits
 An increase in the anticipated growth rate of profits
increases the value of a share of stock.
3) Discount rate
 A rise in interest rates--or even an anticipated rise in
interest rates--decreases the value of a share of stock.
4) Perception toward risk
 An increase in the perceived riskiness of future profits
decreases the value of a share of stock.
Financial intermediaries
• Most people do not enter financial markets directly.
• Rather, use financial intermediaries.
• Financial intermediary is an institution that is entitled
legally to collect funds from lenders/depositors and
distributes these funds to borrowers.
• Financial intermediaries are basically two types:
 Bank financial intermediaries: include commercial
banks, credit unions, savings and loan associations, mutual
savings banks, etc.
 MSB: a bank without shareholders in which the depositors
are technically the owners.
• BFIs are financial institutions that accept deposits and
make loans.
 Since they are involved in the creation of deposits, an
important component of the money supply, their behavior
plays an important role in determining the money supply.
 Non-bank financial intermediaries: include insurance
companies, mutual trust funds, investment companies,
pension funds, etc.
 Mutual fund: is an institution that sells shares to the public
and uses the proceeds to buy a selection, or portfolio, of
various types of stocks, bonds, or both stocks and bonds.
 They allow their shareholders to diversify risk.
 Investment company: a company that holds securities in
other companies purely for investment.
• The process of indirect finance using financial
intermediaries is called financial intermediation.
• The indirect finance is the primary route for moving funds
from lenders to borrowers.
Advantages of financial intermediaries
• FIDs are a more important source of financing for firms
than financial markets are.
• The most important advantages of FIDs in an economy are:
1) They reduce the costs of transaction.
TC--the time and money spent in carrying out financial
transactions.
2)They alleviate problems created by asymmetric
information.
• In financial markets, one party does not often have enough
information about the other party to make accurate
decisions.
 This inequality in information is called asymmetric
information.
• Asymmetric information creates problems in the financial
system on two fronts:
 before the transaction is made (adverse selection) and
 after the transaction is made (moral hazard).
Difference
• Adverse selection is a problem of asymmetric information
before entering into a transaction.
• Moral hazard is a problem of asymmetric information after
the transaction has occurred.
 In financial market, AS makes loans made to bad
borrowers.
 Moral hazard in financial markets is the risk (hazard) that
the borrower might engage in activities that are undesirable
(immoral).
 Moral hazard lowers the probability that the loan will be
repaid, so the lenders may decide that they would not make
a loan.
• Financial intermediaries can alleviate the problems created
by adverse selection and moral hazard.
 They screen loan applications before lending and monitor
repayment after lending so as to avoid non-performing
(bad) debt.
3) They make possible the separation of saving and
investment decisions.
4) They reduce risk.
• A financial intermediary can make diversified many loans.
“They don’t put all eggs in one basket”
5) They serve as maturity transformation
• Lenders prefer to hold short-term maturity and capital
certain assets.
• Borrowers prefer loan on long-term maturity assets for
investments.
• FIDs have large number of depositors, but the
proportion of withdrawal is small.
• Therefore, financial intermediaries can satisfy or
transform the interest of depositors and borrowers
on maturity at the same time.
6) Liquidity
• FIDs hold some funds idle as cash to provide
liquidity to individual depositors.
7) They (particularly banks) facilitate the payment
system.
• Banks create a special asset that people can use as a
medium of exchange.
 2.4. Interest rates and their measurement
 The acts of saving and lending, and borrowing and
investing, are significantly influenced by and tied
together by the interest rate.
 The interest rate is the price a borrower must pay to
secure scarce loanable funds from a lender for an
agreed-upon time period.
• The interest rate is the price paid for the use of
money for a period of time.
• Interest rate is the ratio of interest received to the
amount lent.
 5 - 31

Functions of the Interest Rate in the Economy

 The interest rate ensures the flow of current

savings into investment to promote economic
growth.
 It rations the available supply of credit,
generally providing loanable funds to those
investment projects with the highest return.
 It brings the supply of money into balance
with the public’s demand for money.

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 5 - 32

Functions of the Interest Rate in the Economy

 The interest rate serves as an important tool for

government policy through its influence on the
volume of savings and investment.

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Calculating interest rates
• Yield to maturity is the most accurate measure of
interest rates.
• Yield to maturity is the interest rate that equates the
present value of payments received from a debt
instrument with its value today.
• The procedure we calculate yield to maturity varies
for the four types of credit market instruments.
1) Simple loan: is a credit market instrument in
which the lender provides the borrower with an
amount of funds (called the principal) that must be
repaid to the lender at the maturity date along with an
additional payment (interest).
Ex: commercial loans to businesses
• To calculate the yield to maturity on a simple loan,
we must equate the present value of the future
payments to the today’s value of a loan.
• If we denote the present value as PV and the future
value as FV, then PV
 = today’s value of the loan
Example: A one-year loan $100 is lent, and $110
must be paid back. Solve for the yield to maturity i
$100
2) Fixed- payment loan: is a credit market
instrument in which the lender provides the borrower
with an amount of funds which must be repaid by
making the same payment every period (such as
monthly), consisting of part of the principal and
interest for a set of number of years.
Ex: mortgage loans
• FPL has the same payment every period throughout
the life of the loan.
• To calculate the yield to maturity for a FPL, we
equate today’s value of the loan with its sum of the
present values of all payments.
• For any fixed-payment loan,

where LV is today’s loan value

FP is fixed yearly payment
n is number of years until maturity
Example: You borrowed $1,000 and the yearly
payment $ 126 for the next 25 years. Calculate the
yield to maturity.

The yield to maturity that solves this equation is 12%.

3) Coupon Bond: is a credit market instrument that
pays the owner of the bond a fixed interest payment
( coupon payment) every year until the maturity date,
when the principal ( face value) is repaid.
Coupon rate: is the amount of the yearly coupon
payment expressed as a percentage of the face value
of the bond.
Example: The coupon bond has a yearly coupon
payment of $100 and a face value of $1,000. The
coupon rate is then , or 10%.
 To calculate the yield to maturity for a coupon bond, equate
today’s value of the bond with the sum of the present
values of all the coupon payments and the present value of
the final payment of the face value of the bond.
• For any coupon bond,

where P = today’s price of coupon bond

C = yearly coupon payment
F = face value of the bond
n = years to maturity date
Ex: A coupon bond with $ 1,000 face value pays a
coupon payment $ 100 per year for 10 years. If the
current price of this bond is &1,200, calculate the
yield to maturity.
The yield to maturity that solves this equation is
7.13%.
Relationship between price of bond and yield to
maturity
Yields to maturity on a 10%-coupon-rate bond
maturing in ten years (Face value = $1,000)
Price of Bond ($) Yield to Maturity (%)
1,200 7.13
1,100 8.48
1,000 10.00
900 11.75
800 13.81
Three interesting facts:
1. When the coupon bond is priced at its face
value, the yield to maturity equals the coupon
rate.
2. The price of a coupon bond and the yield to
maturity are negatively related; that is, as the
yield to maturity rises, the price of the bond
falls. As the yield to maturity falls, the price of
the bond rises.
3. The yield to maturity is greater than the coupon
rate when the bond price is below its face value.
Consol or Perpetuity: special case of a coupon
bond
- has no maturity date and no repayment of principal
- makes fixed coupon payments of $C forever.

where P = today’ price of the consol

C = yearly payment
For example, if a consol pays $100 per year forever
and the interest rate is 10%, its price will be
---- the yield to maturity for the consol
For example, with a consol that pays $100 yearly and
has a price of $2,000, the yield to maturity is 5% ( =
$100/$2,000).
4) Discount Bond (Zero-coupon bond): is a credit
market instrument that is bought at a price below its
face value ( at a discount), and the face value is repaid
at the maturity date.
• A discount bond does not make any interest
payments ; it just pays off the face value.
• For any one-year discount bond, the yield to maturity is
given as:
, where F is face value of the discount bond and P
is current price of the discount bond
Example: Consider a discount bond which pays off a
face value of $1,000 in one year’s time. If the current
purchase price of this bond is $900, obtain the yield to
maturity.
 Equating this price to the present value of the
$1,000 received in one year gives us;

Solving for
Current Yield: Alternative measure of interest rates
Even though the yield to maturity is the most accurate
measure of interest rates, it is difficult to calculate it.
• The current yield is an approximation of the yield to
maturity on coupon bonds that equals yearly
coupon payment divided by the price of the coupon
bond.

where is current yield, P is price of the coupon

bond and C is yearly coupon payment.
• For a consol, the current yield is an exact measure
of the yield to maturity.
• When a coupon bond has a long term to maturity
(20 years or more), it is very much like a consol.
• better approximates the yield to maturity when the bond’s
price is nearer to the bond’s par value and the maturity of
Interest Rates vs. rate of returns
• For any security, 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.
Example: A $1,000-face-value coupon bond with a
coupon rate of 10% 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 a one-year rate of
return for holding this bond.
 = = 0.30 = 30%
• However, the yield to maturity is only 10 %.
 The return on a bond will not necessarily equal the interest
rate on that bond.
• More generally, the return on a bond held from time t to
time can be written as:

where RET = return from holding the bond from time t to

time t +1
= price of the bond at time t
= price of the bond at time
C = coupon payment
The return formula can be rewritten as

• The first term is the current yield (the coupon

payment over the purchase price).

• The second term is the rate of capital gain, or the

change in the bond’s price relative to the initial
purchase price.
= g ---- rate of capital gain
Thus, = + g
Determination of the market rate of interest
• Interest rates are among the most important
macroeconomic variables.
• They affect personal decisions such as
- whether to consume or save
- whether to buy a house or to hold money
- whether to purchase bonds or put funds into a
savings account.
• Interest rates also affect the economic decisions of
businesses and households, such as
- whether to use their funds for investment or to
save their money in a bank.
• In a monetary economy, credit markets will arise
because
Different households have different preferences
for present versus future consumption.
Businesses can make investments that are
profitable enough to enable them to pay back
interest.
• There are many different interest rates in the economy
– Differences due to the length of loans, the risk
involved in a loan, and the tax treatment of interest
payments
– Generally, however, all interest rates tend to move in
the same direction.
• There are different theories on how the overall
level of nominal interest rates (which we refer
to as simply “interest rates”) is determined:
1. The classical theory of interest rates
2. The liquidity preference (cash balances)
theory of interest rates
3. The loanable funds theory of interest
 5 - 51

The Classical Theory of Interest Rates

 The classical theory argues that the rate of

interest is determined by two forces:
 the supply of savings, derived mainly from
households, and
 the demand for investment capital, coming mainly
from the business sector.

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 5 - 52

The Classical Theory of Interest Rates

Household Savings
 Current household savings equal the difference
between current income and current
consumption expenditures.
 Individuals prefer current over future
consumption, and the payment of interest is a
reward for waiting.
 Higher interest rates encourage the substitution
of current saving for current consumption.
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 5 - 53

The Classical Theory of Interest Rates

The Substitution Effect

Relating Savings and Interest Rates
Interest
Rate
r2 
r1 

Current
S1 S2 Saving

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 5 - 54

The Classical Theory of Interest Rates

Business and Government Savings

 Most businesses hold savings balances in the
form of retained earnings, the amount of
which is determined principally by business
profits, and to a lesser extent, by interest rates.
 Income flows in the economy and the pacing
of government spending programs are the
dominant factors affecting government savings
(budget surplus).
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 5 - 55

The Classical Theory of Interest Rates

The Demand for Investment Funds

Interest
Rate
r2 
r1 

Investment
I2 I1 Spending

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 5 - 56

The Classical Theory of Interest Rates

The Equilibrium Rate of Interest

In the Classical Theory of Interest Rates
Interest
Rate Investment Savings

rE 

Savings &
QE Investment

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 5 - 57

The Classical Theory of Interest Rates

Limitations
 Factors other than savings and investment that
affect interest rates are ignored. For example,
many financial institutions can “create” money
today by making loans to the public.
 Today, economists recognize that income is
more important than interest rates in
determining the volume of savings.

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 5 - 58

The Classical Theory of Interest Rates

Limitations … continued
 In addition to the business sector, both
consumers and governments are also important
borrowers today.

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 5 - 59

The Liquidity Preference (Cash Balances)

Theory of Interest Rates

 The liquidity preference (or cash balances)

theory of interest rates is a short-term theory
that was developed for explaining near-term
changes in interest rates, and hence, is more
relevant for policymakers.
 According to the theory, the rate of interest is
the payment to money (cash balances) holders
for the use of their scarce resource (liquidity),
by those who demand liquidity (i.e. money or
cash balances).
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 5 - 60

The Liquidity Preference (Cash Balances)

Theory of Interest Rates

 The demand for liquidity stems from:

the transactions motive - the purchase of goods

and services
 the precautionary motive - to cope with future
emergencies and extraordinary expenses
 the speculative motive - a rise in interest rates
results in lower bond prices
  and  depend on the level of national income,
business sales, and prices (but not interest rates).
So, demand due to  and  is fixed in the short term.
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 5 - 61

The Liquidity Preference (Cash Balances)

Theory of Interest Rates

The Total Demand for Money or Cash Balances

in the Economy
Interest
Rate  : transactions
Total Demand demand
= ++  : precautionary
demand
r   : speculative
demand
+ 
Quantity of
Money / Cash
K Q Balances

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 5 - 62

The Liquidity Preference (Cash Balances)

Theory of Interest Rates

 In modern economies, the money supply is

controlled, or at least closely regulated, by the
government.
 The supply of money (cash balances) is often
assumed to be inelastic with respect to interest
rates, since government decisions concerning
the size of the money supply should
presumably be guided by public welfare.

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 5 - 63

The Liquidity Preference (Cash Balances)

Theory of Interest Rates

The Equilibrium Interest Rate

In the Liquidity Preference Theory
Interest
Rate Money
Supply

rE  Total
Demand

Quantity of
Money / Cash
QE Balances

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 5 - 64

The Liquidity Preference (Cash Balances)

Theory of Interest Rates

Limitations
 The liquidity preference theory is a short-term
approach. In the longer term, the assumption
that income remains stable does not hold.
 Only the supply and demand for money is
considered. A more comprehensive view that
considers the supply and demand for credit by
all actors in the financial system - businesses,
households, and governments - is needed.
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 5 - 65

The Loanable Funds Theory of Interest

 The popular loanable funds theory argues that

the risk-free interest rate is determined by the
interplay of two forces:
 the demand for credit (loanable funds) by
domestic businesses, consumers, and
governments, as well as foreign borrowers
 the supply of loanable funds from domestic
savings, dishoarding of money balances, money
creation by the banking system, as well as foreign
lending
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 5 - 66

The Loanable Funds Theory of Interest

The Demand for Loanable Funds

 Consumer (household) demand is relatively
inelastic with respect to the rate of interest.
 Domestic business demand increases as the
rate of interest falls.
 Government demand does not depend
significantly upon the level of interest rates.
 Foreign demand is sensitive to the spread
between domestic and foreign interest rates.
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 5 - 67

The Loanable Funds Theory of Interest

Total Demand for Loanable Funds (Credit)

Interest
Rate
Total Demand = Dconsumer +
Dbusiness +
Dgovernment +
Dforeign

Amount of
Loanable Funds

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 5 - 68

The Loanable Funds Theory of Interest

The Supply of Loanable Funds

 Domestic Savings. The net effect of income,
substitution, and wealth effects is a relatively
interest-inelastic supply of savings curve.
 Dishoarding of Money Balances. When
individuals and businesses dispose of their
excess cash holdings, the supply of loanable
funds available to others is increased

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 5 - 69

The Loanable Funds Theory of Interest

The Supply of Loanable Funds … continued

 Creation of Credit by the Domestic Banking
System. Commercial banks and nonbank thrift
institutions offering payments accounts can
create credit by lending and investing their
excess reserves.
 Foreign lending is sensitive to the spread
between domestic and foreign interest rates.

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 5 - 70

The Loanable Funds Theory of Interest

Total Supply of Loanable Funds (Credit)

Interest
Rate Total Supply
= domestic savings +
newly created money +
foreign lending –
hoarding demand

Amount of
Loanable Funds

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 5 - 71

The Loanable Funds Theory of Interest

The Equilibrium Interest Rate

Interest
Rate Supply

rE 

Demand
Amount of
QE Loanable Funds

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 5 - 72

The Loanable Funds Theory of Interest

 At equilibrium:
 Planned savings = planned investment across the
whole economic system
 Money supply = money demand
 Supply of loanable funds = demand for loanable
funds
 Net foreign demand for loanable funds = net
exports

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 5 - 73

The Loanable Funds Theory of Interest

Þ Interest rates will be stable only when the

economy, money market, loanable funds
market, and foreign currency markets are
simultaneously in equilibrium.

McGraw Hill / Irwin  2003 by The McGraw-Hill Companies, Inc. All rights reserved.
• Net savers/net lenders supply funds to the credit
market.
• Net borrowers demand funds from the credit
market.
The supply of credit:
• The supply of credit curve is positively sloped.
• At higher interest rates more households and
businesses will become net lenders .
 Even the extremely present-oriented," live -for-
today" individuals prefer to save more of their
incomes.
 Even very profitable businesses will find that they
cannot repay interest out of earnings; they can earn
a better rate of return by becoming net savers.
The demand for credit:
The demand for credit is curve will negatively sloped.
 As the rate of interest falls, more people prefer to
become net borrower.
• At very low rate of interest, even future-oriented
people find that they prefer to consume more in the
present and save less.
• As the rate of interest falls, other things constant,
the quantity demanded of credit rises.
• The market rate of interest is established at the point of
intersection of the supply of and the demand for
loanable funds.
• The demand for loanable funds consists of the demand
for consumer loans (consumption) and business loans
(investment).
• Each varies inversely as the rate of interest rises or falls
• The supply of loanable funds consists mostly of
household saving.
• It is positively related to the rate of interest.
• The interest rate is the price of credit.
• It allocates scarce loanable funds to the highest bidders.
 Real vs. nominal interest rates
• The nominal interest rate is the interest rate as
usually reported: it is the rate of interest that
investors pay to borrow money and that the bank
pays to the depositors.
• It is the rate of exchange between a Birr today and a
Birr in the future.
• The real interest rate is the nominal interest rate
corrected for the effects of inflation.
• Real interest rate (r) = nominal interest rate (i) −
• It is the rate of exchange between a good today and
a good in the future
 Nominal interest rate, i, is not adjusted for inflation.
 Real interest rate, r, is adjusted for inflation.
The Fisher Effect
• The nominal interest rate is the sum of the real
interest rate and the inflation rate:
i= r +Fisher equation, after economist Irving
Fisher (1867–1947).
 The nominal interest rate can change for two
reasons:
1) because the real interest rate changes or
2) because the inflation rate changes.
• According to the Fisher equation, a 1% increase in
the rate of inflation causes a 1% increase in the
nominal interest rate.
 The one-for-one relation between the inflation rate
and the nominal interest rate is called the Fisher
effect.
Two real interest rates: ex-ante and ex-post
• Ex-ante real interest rate-- the real interest rate
that the borrower and lender expect when the loan
is made.
• Ex-post real interest rate-- the real interest rate
actually realized.
• Let denote actual future inflation rate and the
expected future inflation rate
 The ex-ante real interest rate is i- , and
 The ex-post real interest rate is i - .
• The two real interest rates differ when actual
inflation rate differs from expected inflation rate.
Modification of Fisher Effect
• The nominal interest rate cannot adjust to actual
inflation, because actual inflation is not known
when the nominal interest rate is set.
• The nominal interest rate can adjust only to
expected inflation.
 The Fisher effect is more precisely written as
i= r +
• The nominal interest rate i moves one-for-one with
changes in expected inflation rate .
Example: You have made a one-year simple loan
with a 5 % interest rate (i = 5 %) and you expect the
price level to rise by 3 % over the course of the year
( = 3%).

Assignment II: Financial Development and

Economic Growth in Developing Countries