Finance 301 1st Edition Lecture 4 Outline of Last Lecture I. Loanable Funds TheoryII. Demand for Loanable FundsIII. Supply of Loanable FundsIV. Equilibrium Interest RateOutline of Current LectureV. Factors that affect Interest RatesVI. Forecasting Interest RatesCurrent LectureI. Factors that affect Interest Ratesi. Impact of economic growth on interest rates: i. Puts upward pressure on interest rates by shifting demand for loanable funds outward. ii. What is economic growth? Increase in GDP increase in goods in services to make of deficits and units we want economic growth, higher than 3% GDPiii. If economic growth starts, iv. Example mortgage rate interest rate is 4 % if gdp goes to 5 % what is going to happen to that interest rate? The interest rate is going to increase because so much money is borrowed banks actually run short on money, so they are going to raise the interest rate to borrow money so they end up making more money off of the loan, they make the customer compete for this money they start becoming picky and choosy on who they are going to loan to v. When there is a recession people get scared and start saving money instead of spending it, then people are making the banks compete for lowest interest ratesvi.vii. you will eventually see inflationviii. Economic expansion= raise interest rates= start worrying about the inflation, ix. Inflation- the cause of devaluation of currency because when prices go up your currency buys lessx. Government looks at economic growth and raises interest rates to slow the economy downxi. Salaries may not go up as fast as the price of goods but the government doesn’t want this why? Because they cant raise taxes if we cant afford to live and we cant buy as much or have our same standard of livingxii. When a recession hurts unemployment rises and people don’t spend and this is why interest rates lower and it creates job creationxiii. Impact of increased expansion by firms1.2. When people want to borrow money interest rates go up 3. When banks run out of money they start having customerscompete and don’t loan to as many people they want to see what rate we will actually pay for our moneyxiv. Impact of Economic slowdown1.ii. Impact of inflation on interest ratesi. Puts upward pressure on interest rates by shifting supply of funds inward and demand for funds outward.ii. Erving fischer 1938- told us all that interest rates are made up of inflation and reason they go up or down is because of inflationiii. A lot more dolar bills in our dollar supply causes prices to go up because people can afford more and they can by the supply prices go up because there is nothing left and there is less of that good so we start competing for itiv. Ford f150- 100 left- millions of people competing they can raise the price of it always expect 2 % inflation rate and prices do eventually go up over time. Dollar becomes more valuavle in this option price of goods go down but corp revenue goes down and that causes pay cuts and loss of employmentv. Expect in 6 months for prices to rise, demand for money gets higher becausevi. Impact of an Increase in Inflationary Expectations on Interest Rates1.2. Expect in 6 months for prices to rise, demand for money gets higher because prices get higher, but right now the demand for money would go up because people are going to go buy that house now if they can 2% more is 50 dollars to 75 dollars more a month and if money is tight this is a lot vii. Fisher effect: i = E(INF) + iR1. where i = nominal or quoted rate of interest2. E(INF) = expected inflation rate3. iR = real interest rateiii. Impact of Monetary Policy on Interest Ratesi. The Fed reduces (increases) the money supply, it reduces (increases) the supply of loanable funds, putting upward (downward) pressure on interest rates. ii. If fed puts money into money supply interest rates go down because the banks have more money to give outiv. Impact of the Budget Deficit on Interest Ratesi. Crowding-out Effect: Given a certain amount of loanable funds supplied to the market, excessive government demand for funds tends to “crowd out” the private demand for funds. ii. Government can crowd out an individual because they can borrowat any interest rate and the banks will loan to the government before they will loan to usiii. Flow of Funds between the Federal Government and the Private Sector1.2. Budget deficita. Medicareb. foreign warsc. Less taxes- the economy is not doing well if you take 6% out of work force that’s 6% that’s not paying money at all and then we cant pay budgetd. Stimulus spending- kick start economy got interest rates low and they started spending money themselves e. Interest paymentsf. What can they do to kick start the economy- by lowering the interest rates, demand goes down because of a recession , what we are hoping fixes ishaving more taxes, that’s why government tries to control money supply with interest ratesv. Impact of Foreign Flows of Funds on Interest Ratesi. Interest rate for a certain currency is determined by the demand for funds in that currency and the supply of funds available in that currency.ii.iii. Interest Rates movements over time1.II. Forecasting Interest Ratesi.Net Demand (ND) should be forecast: i.ND = DA – SAii.ND = (Dh + Db + Dg + Dm + Dr) – (Sh + Sb + Sg + Sm +