Chapter 5: The Determinants of Interest Rates: Competing Ideas Key Topics: - The Classical Theory of Interest: Assumptions and Conclusions (p. 138) - The Substitution Effect and Investment Demand (p. 139) - Liquidity Preference Theory: Demand and Supply of Cash Balances (p. 144) - The Credit Theory of Interest Rates: Demand and Supply of Loanable Funds (p. 150-155) 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. . b. It rations the availability supply of credit. c. It brings the supply of money into balance with the public's demand for money. 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. Consider Problem 2 and Demand/Supply graph Classical Theory of Interest Rates: 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. The classical theory of interest rates helps us to understand some of the long-term forces driving interest rates. - 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. - Savings: Current Income – Current Consumption o Income Effect o Wealth Effect o Substitution Effect  Consider Problem 3 (conflict signals from int. rate change). - 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 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.The Classical Theory of Interest Rates The internal rate of return (r) equates the total cost of an investment project with the future net cash flows (NCF) expected from that project discounted back to their present values. Cost of project =The demand for investment funds … continued     nnrNCF...rNCFrNCF 1112211 Another method of investment analysis is the net present value (NPV) approach.5-15 . The Classical Theory of Interest RatesThe Cost of Capital and the Business Investment DecisionA15%B12%C10%D8%E7%Dollar Cost of Investment ProjectsExpected Internal Rates of Return on Alternative Investment ProjectsCost of Capital Funds = 10%C10%D8%E7%– acceptable– acceptable– indifferentunprofitableunprofitable5-16The Classical Theory of Interest RatesThe Equilibrium Rate of Interest In the Classical TheoryRate of interest(% per annum)Volume of savings & investment ($billions)rEQE = $200 billion-Demand forInvestmentVolume of SavingsESSDD5-18 Liquidity Preference: 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. - The liquidity preference (or cash balances) theory of interest rates. - 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. 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 ofcapital loss resulting from falling bond prices will cause many investors to demand money or near-money assets instead of bonds. Total Demand for Money or Cash Balances And the Equilibrium Rate of Interest5-27 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. (Exhibit 5-4) 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 (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. 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. The liquidity preference considers