Finance 301 1st Edition Lecture 3 Outline of Last Lecture I Role of Financial Institutions II Comparison of Roles among Financial Institutions III How the Internet Facilitates Roles of Financial Institutions IV Summary of Institutional Sources and Uses of Funds V Organizational Structure of a Financial Conglomerate VI Credit Risks for Financial Institutions VII Credit Crisis Outline of Current Lecture I Loanable Funds Theory II Demand for Loanable Funds III Supply of Loanable Funds IV Equilibrium Interest Rate Current Lecture I Loanable Funds Theory i The Loanable Funds Theory suggests that the market interest rate is determined by the factors that control supply of and demand for loanable funds ii Can be used to explain i Movements in the general level of interest rates in a particular country ii Why interest rates among debt securities of a given country vary iii Movements on rates are based on supply and demand for it II Demand For Loanable Funds i Household demand for loanable funds i Demand money to buy household to buy a car medical expenses college These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute ii 1 Lower interest rate the better 2 If we did not care what the interest rate was it was an absolute emergency there is still going to be a lot more money at 2 then 6 because there s less interest money to pay back it is more attractive more people can afford the 2 percent than the 6 percent ii Business demand for loanable funds n NPV INV t 1 CFt 1 k t NPV net present va lue of project INV initial investment CFt cash flow in period t k required rate of return on project i ii Present value formula almost the same You have investment which makes it net instead of present value business has a demand for loanable funds when they have positive cash flows iii Business would borrow more money at 2 as well because the cost of investment is lower maay be able to start 10 projects at 2 percent and only 3 at 6 percent iv Companies can also borrow money by issuing stock private equity sell bonds v Companies have a lot more borrowing ability npv greater than 0 is when they borrow money vi They look at their internal rate of return and see if it has a irr greater than their discount rate k vii iii 1 Line is less steep than household because they don t have to take loans this is only if they need money 2 Issue stock instead of bonds because bonds are gonna have similar interest rate to a loan from the bank 3 Issue stock to gain capital and you don t have to pay back stock 4 Interest rates were at 18 at one point Government demand for loanable funds i Federal government borrow when they run a deficit ii Run a deficit because tax revenue has decreased import more than you export pay for a war Government spending is higher and tax revenue is lower iii You should have deficits when the economy is doing bad to stimulate growth when the economy gets back to being better you need to stop running a deficit the problem is that the government ends up not cutting out of it they cant sell their bonds they should be controlling their spending deficits is when you are going to recess recession iv Interest inelastic means that independent of interest rates doesn t t matter what the interest rate is v They can do this because they can print money vi iv 1 County and state aren t like federal government they cant always borrow money more sensitive to interest rate 2 Why would u loan money to federal instead of state county government its safer county and states aren t as safe because they can t print money out like the federal government can They have to raise taxes Foreign Demand for Loanable Funds i A country s demand for foreign funds depends on the interest rate differential between the two ii The greater the differential the greater the demand for foreign funds iii The quantity of U S loanable funds demanded by foreign governments will be inversely related to U S interest rates iv Foreign countries want to borrow money from us or we want to borrow from them We borrow money in a foreign country instead of our own because they have a lower interest rate Each country has different interest rates v Risk currency risk our dollar is worth more or less in other places vi Benchmark interest rates vii US 0 25 viii China 6 ix Brazil 11 x Japan 0 xi Australia 2 5 xii Mexico 3 xiii Tells you higher percentage the higher likely they are to default foreign investors in that country not government itself xiv They have high inflation high interest rates like brazil and china they are trying to slow down their economy xv We want foreign investors to borrow from us low interest rates same with Japan xvi I 1 Not as much money borrowed over seas because of the currency risk Aggregate demand for loanable funds a The sum of the quantities demanded by the separate sectors at any given interest rate b c Bunch of money being demanded at low interest rates and still a lot at high interest rates III Supply of Loanable Funds i Largest supplier households ii iii Supply put it in the bank invest invest in mutual funds we buy stock Aggregate supply of funds Is the combination of all sector supply schedules along with the supply of funds provided by the Fed s monetary policy iv Federal reserve print money and buy bonds themselves mortgage back bonds They contribute to the supply of loanable funds v i Bottom 2 percent top 6 percent less money given out at 2 percent because aren t making a lot of money off of it ii So far out to the right because most people have a 401k IV Equilibrium Interest Rate i Aggregate Demand for funds DA i DA Dh Db Dg Dm Df ii Dh household demand for loanable funds iii Db business demand for loanable funds iv Dg federal government demand for loanable funds v Dm municipal government demand for loanable funds vi Df foreign demand for loanable funds ii Aggregate Supply of funds SA i SA Sh Sb Sg Sm Sf ii Sh household supply for loanable funds iii Sb business supply for loanable funds iv Sg federal government supply for loanable funds v Sm municipal government supply for loanable funds vi Sf foreign supply for loanable funds iii Interest Rate Equilibrium i ii Demand line if demand goes up interest rate is going to rise if demand goes down interest rate is lower