ECONOMIC FORCES THAT AFFECT INTEREST RATES

Although it is useful to identify those who supply or demand loanable funds, it is also
necessary to recognize the underlying economic forces that cause a change in the supply of
or the demand for loanable funds. The following economic factors influence the demand for
or supply of loanable funds and therefore influence interest rates.

Impact of Economic Growth on Interest Rates

Changes in economic conditions cause a shift in the demand schedule for loanable funds,
which affects the equilibrium interest rate.

Illustration. When businesses anticipate that economic conditions will improve, they revise
upward the cash flows expected for various projects under consideration. Consequently,
businesses identify more projects that are worth pursuing, and they are willing to borrow
more funds. Their willingness to borrow more funds at any given interest rate reflects an
outward shift in the demand schedule (to the right).

The supply of loanable-funds schedule may also shift in response to economic growth, but it
is more difficult to know how it will shift. It is possible that the increased expansion by
businesses will lead to more income for construction crews and others who service the
expansion. In this case, the quantity of savings, and therefore of loanable funds supplied at
any possible interest rate, could increase, causing an out-ward shift in the supply schedule.
There is no assurance that the volume of savings will actually increase, however. Even if a
shift occurs, it will likely be of a smaller magnitude than the shift in the demand schedule.

Overall, the expected impact of the increased expansion by businesses is an out-ward shift in
the demand schedule and no obvious change in the supply schedule (Exhibit 2.8). the shift in
the aggregate demand schedule to DA2 in the exhibit causes an increase in the equilibrium
interest rate to і2
Just as economic growth puts upward pressure on interest rates, an economic showdown puts
downward pressure on the equilibrium interest rate.
Interest rate SA

і2

DA2

DA

Quantity of loanable funds

Exhibit 2.8 Impact of increased expansion by firms

Illustration. A slowdown in the economy will cause the demand schedule to shift inward (to
the left), reflecting less demand for loanable funds at any possible interest rate. The supply
schedule may possibly shift a little, but the direction of its shift is uncertain. Once could
argue that a slowdown should cause increased saving at any possible interest rate as
households prepare for the possibility of being laid off. At the same time, the gradual
reduction in labor income that occurs during an economic slowdown could reduce
household’s ability to save. Historical data support this latter expectation. Any shift that
does occur will likely be minor relative to the shift in the demand schedule. Therefore, the
equilibrium interest rate is expected to decrease, as illustrated in Exhibit 2.9
Interest rate SA

і2

і
DA

DA2

Quantity of loanable funds

Exhibit 2.9 Impact of an Economic slowdown

Impact of Inflation on Interest Rates

Changes in inflationary expectations can affect interest rates by affecting the amount of
spending by households or businesses. Decisions to spend affect the amount saved (supply
of funds) and the amount borrowed (demand for funds).

Illustration. Assume the U.S inflation rate is expected to increase. Households that supply
funds may reduce their savings at any interest rate level so that they can make more
purchases now before prices rise. This shift in behavior is reflected by an inward shift (to the
left) in the supply curve of lonable funds. In addition, households and businesses may be
willing to borrow more funds at any interest rate level so that they can purchase products
now before prices increase. This is reflected by an outward shift (to the right) in the demand
curve for loanable funds. These shifts are illustrated in Exhibit 2.10. The new equilibrium
interest rate is higher because of the shifts in saving and borrowing behavior.
Interest rate SA2
SA2 SA

і2

і
DA2

DA

Quantity of Loanable Funds

Exhibit 2.10 Impact of an increase in inflationary expectations on interest rates

Fisher Effect. More than 50 years ago, Irving Fisher proposed a theory of interest rate
determination that is still widely used today. It does not contradict the loanable funds theory
but simply offers an additional explanation for interest rate movements. Fisher proposed that
nominal interest payments compensate savers in two ways. First, they compensate for a
saver’s reduced purchasing power. Second, they provide an additional premium to savers for
forgoing present consumption. Savers are willing to forgo consumption only if they receive
a premium on their savings above the anticipated rate of inflation, as shown in the following
equation:

і = E(INF) + іR

Where і = nominal or quoted rate of interest

E(INF) = expected inflation rate

іR = real interest rate

This relationship between interest rates and expected inflation is often referred to as the
Fisher effect. The difference between the nominal interest rate and the expected inflation
rate is the real return to a saver after adjusting for the reduced purchasing power over the
time period of concern. It is referred to as the real interest rate because, unlike the nominal
rate of interest, it adjusts for the expected rate of inflation. The preceding equation can be
rearranged to express the real interest rate as

іR = і – E(INF)

When the inflation rate is higher than anticipated, the real interest rate is relatively low.
Borrowers benefit because they were able to borrow at a lower nominal interest rate than
would have been offered if inflation had been accurately forecasted. When the inflation rate
is lower than anticipated, the real interest rate is relatively high and borrowers are adversely
affected.

Throughout the text, the term interest rate will be used to represent the nominal, or quoted,
rate of interest. Keep in mind, however, that because of inflation, purchasing power is not
necessarily increasing during periods of rising interest rates.

Impact of Monetary Policy on Interest Rates

The Federal Reserve can affect the supply of loanable funds by increasing or reducing the
total amount of deposits held at commercial banks or other depository institutions. The
process by which the Fed adjusts the money supply. When the Fed increases the money
supply, it increased the supply of loanable funds, which places downward pressure on
interest rates.
If the Fed reduces the money supply, it reduces the supply of loanable funds. Assuming no
change in demand, this action places upward pressure on interest rates.

Impact of the Budget Deficit on Interest Rates

When the government enacts fiscal policies that result in more expenditures than tax revenue,
the budget deficit is increased. Consider how an increase in the government deficit would
affect interest rates, assuming no other changes in habits by consumers and firms occur. A
higher government deficit increases the quantity of loanable funds demanded at any
prevailing interest rate, causing an outward shift in the demand schedule. Assuming no
offsetting increase in the supply schedule, interest rates will rise. Given a certain amount of
loanable funds supplied to the market (through savings), excessive government demand for
these funds tends to “crowd out” the private demand (by consumers and corporations) for
funds. The government may be willing to pay whatever is necessary to borrow these funds,
but the private sector may not. This impact is known as the crowding-out effect. Exhibit
2.11 illustrates the flow of funds between the government and the private sector.

$ $

Regierung

Taxes Security Treasury Government

Purchases Securities Expenditures

$ $ $
Private sector

Exhibit 2.11 Flow of Funds between the Government and the Private Sector

There is a counter argument that the supply schedule might shift outward if the government
creates more jobs by spending more funds than it collects from the public (this is what causes
the deficit in the first place). If this were to occur, the deficit might not necessarily place
upward pressure on interest rates. Much research has investigated this issue and, in general,
has shown that higher deficits place upward pressure on interest rates.

Impact of Foreign Flows of Funds on Interest Rates

GLOBAL Aspects. The interest rate for a specific currency is determined by the demand for
funds denominated in that currency and the supply of funds available in that currency.

Illustration. The supply and demand schedules for the U.S. dollar and for Brazil’s currency
(the real) are compared for a given point in time in Exhibit 2.12. Although the demand
schedule for loanable funds should be downward sloping for every currency and the supply
schedule should be upward sloping, the actual positions of these schedules vary among
currencies. First, notice that the demand and supply curves are farther to the right for the
dollar than for the Brazilian real. The amount of dollar-denominated loanable funds supplied
and demanded is much greater than the amount of Brazilian real-denominated loanable funds
because the U.S. economy is much larger than Brazil’s economy.

Demand and supply of Demand and supply of Funds

Funds Denominated in U.S $ Denominated in the Brazilian Real

$
S$

Interest Rate for the Real

Interest Rate for $

ii
i

D
D$

Quantity of $ Quantity of the Brazilian Real

Exhibit 2.12 Demand and supply schedules for loanable funds denominated in U.S. Dollars
and Brazilian Real
Also notice that the positions of the demand and supply schedules for loanable funds are
much higher for the Brazilian real than for the dollar. The supply schedule for loanable
funds denominated in the Brazilian real shows that hardly any amount of savings would be
supplied at low interest rate levels because the high inflation in Brazil encourages households
to spend all of their disposable income before prices increase more. It discourages
households from saving unless the interest rate is sufficiently high. In addition, the demand
for loanable funds in the Brazilian real shows that borrowers are willing to borrow even at
very high rates of interest because they want to make purchases now before prices increase.
Firms are willing to pay 20 percent interest on a loan to purchase machines whose prices will
have increased by 30 percent by next year.
Because of the different positions of the demand and supply schedules for the two currencies
shown in Exhibit 2.12, the equilibrium interest rate is much higher for the Brazilian real than
for the dollar. As the demand and supply schedules change over time for a specific currency,
so will the equilibrium interest rate. For example, if Brazil’s government could substantially
reduce the local inflation, the supply schedule of loanable funds dominated in real would
shift out (to the right) while the demand schedule of loanable funds would shift in (to the
left), which would result in a lower equilibrium interest rate. Investors from other countries
commonly invest in savings accounts in countries such as Brazil where the interest rates are
high. However, the currencies of these countries usually weaken over time, which may more
than offset the interest rate advantage.

In recent years, massive flows of funds have shifted between countries, causing abrupt
adjustments in the supply of funds available in each country and therefore affecting interest
rates. In general, the shifts are driven by large institutional investors seeking in high return
on their investments. These investors commonly attempt to invest funds in debt securities in
countries where interest rates are high and where the currency is not expected to weaken.

Summary of Forces that Affect Interest Rates

In general, economic conditions are the primary forces behind a change in the supply of
savings provided by households or a change in the demand for funds by households,
businesses, or the government. The saving behavior of the households that supply funds in
the United States is partially influenced by U.S fiscal policy, which determines the taxes paid
by U.S. households and thus determines the level of disposable income. The Federal
Reserve’s monetary policy also affects the supply of funds in the United States because it
determines the U.S money supply. The supply of funds provided to the United States by
foreign investors is influenced by foreign economic conditions, including foreign interest
rates.
The demand for funds in the United States in indirectly affected by U.S monetary and fiscal
policies because these policies influence economic conditions such as economic growth and
inflation, which affect business demand for funds. Fiscal policy determines the budget
deficit and therefore determines the federal government demand for funds.
FORECASTING INTEREST RATES
Exhibit 2.14 summarizes the key factors that are evaluated when forecasting interest rates.
With an understanding of how each factor affects interest rates, it is possible to forecast how
interest rates may change in the future. When forecasting household demand for loanable
funds, it may be necessary to assess consumer credit data to determine the borrowing
capacity of households. The potential supply of loanable funds provided by households may
be determined in a similar manner by assessing factors that affect the earning power of
households.

Business demand for loanable funds can be forecasted by assessing future plans for corporate
expansion and the future state of the economy. Federal government demand for loanable
funds could be influenced by the future state of the economy because it affects tax revenues
to be received and the amount of unemployment compensation to be paid out, factors that
affect the size of the government deficit. The Federal Reserve System’s money supply
targets may be assessed by reviewing public statements about the Fed’s future objectives,
although those statements are somewhat vague.
To forecast future interest rates, the net demand for funds (ND) should be forecast:
ND = DA - SA
= (Db + Db + Ds + Dm + Df) - (Sb + Sb + Ss + Sm + Sf)

If the forecasted level of ND is positive or negative, a disequilibrium will exist temporarily.

If positive, it will be corrected by a downward adjustment. The larger the forecasted
magnitude of ND, the larger the adjustment in interest rates.

Some analysts focus more on changes in DA and SA than on estimating the aggregate level of
DA and SA. For example, assume that today the equilibrium interest rate in 7 percent. This
interest rate will change only if DA and SA change to create a temporary disequilibrium. If
the government demand for funds (Dg) is expected to increase substantially, and no other
components are expected to change, DA will exceed SA, placing upward pressure on interest
rates. Thus, the forecast of future interest rates can be derived without estimating every
component comprising DA and SA.
 Future state of
foreign Future foreign
economies and demand for U.S
expectations of
Funds
exchange rate
movements
Future level of
household Future
incomes Future demand
household for
demand for loanable
Household
funds funds
plans to borrow

Future plans for

expansion
Future business
demand for
Future state of Future volume
funds
the economy of business Forecast
(Economic of
growth, interest
unemployment, Future volume
of government rates
and inflation)
revenues
Future
government
Future demand for
government funds
expenditures

Future level of
household Future savings
income by households
and others
Fed’s future
policies on Future
money supply supply of
growth loanable
Future foreign funds
Future state of supply of
foreign economies loanable funds
and expectations in the U.S.
of exchange rate
movements
Exhibit 2.14 Framework for forecasting interest rates