Chapter Three

Interest Rate, its structure

and How it’s determined
Interest rates are among the most closely watched variables in the
economy. Their movements are reported almost daily by the news media
because they directly affect our everyday lives and have important
consequences for the health of the economy. They affect personal
decisions such as whether to consume or save, whether to buy a house,
and 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 to invest in new
equipment for factories or to save their money in a bank.

Before we can go on with the study of money, banking, and financial

markets, we must understand exactly what the phrase
1
interest rates
means.
1- Measuring Interest Rates:
a) Credit Market Instruments:
In the previous chapters you were introduced to a number
of credit market instruments, which fall into four types:
1. A simple loan provides the borrower with an amount
of funds (principal) that must be repaid to the lender
at the maturity date along with an additional amount
known as an interest payment. For example, if a
bank made you a simple loan of LE 1000 for one
year, you would have to repay the principal of LE
1000 in one year's time along with an additional
interest payment of, say, LE 100. Commercial loans
2

to businesses are often of this type.

2- A fixed-payment loan provides a borrower with
an amount of funds that is to be repaid by
making the same payment every month,
consisting of part of the principal and interest
for a set number of years. For example, if you
borrowed LE 1000, a fixed-payment loan might
require you to pay LE 126 every year for 25
years. Installment loans (such as auto loans)
and mortgages are frequently of the fixed-
payment type.
3
3- A coupon bond pays the owner of the bond a fixed
interest payment (coupon payment) every year
until the maturity date, when a specified final
amount (face value or par value) is repaid. The
coupon payment is so named because the
bondholder used to obtain payment by clipping a
coupon off the bond and sending it to the bond
issuer, who then sent the payment to the holder.
Nowadays, for most coupon bonds it is no longer
necessary to send in coupons to receive these
payments. 4
A coupon bond is identified by three pieces of
information. First is the corporation or
government agency that issues the bond.
Second is the maturity date of the bond. Third
is the bond's coupon rate, the pound amount of
the yearly coupon payment expressed as a
percentage of the face value of the bond. In our
example, the coupon bond has a yearly coupon
payment of LE 100 and a face value of LE 1000.
The coupon rate is then LE 100/LE 1000 = 0.10,
or 10%. Treasury bonds and notes and
corporate bonds are examples of coupon
5
bonds.
4. A discount bond (also called a zero-coupon bond)
is bought at a price below its face value (at a
discount), and the face value is repaid at the
maturity date. Unlike a coupon bond, a discount
bond does not make any interest payments; it just
pays off the face value. For example, a discount
bond with a face value of LE 1000 might be
bought for LE 900 and in a year's time the owner
would be repaid the face value of LE 1000.
Treasury bills, Egyptian savings bonds, and long-
term zero-coupon bonds are examples of
discount bonds. 6
These four types of instruments require payments at
different times: Simple loans and discount bonds
make payment only at their maturity dates,
whereas fixed-payment loans and coupon bonds
have payments periodically until maturity. How
would you decide which of these instruments
provides you with more income? They all seem so
different because they make payments at different
times. To solve this problem, we use the concept
of present value to provide us with a procedure for
measuring interest rates on these different types
of instruments. 7
b) Determination of Interest Rate:

Interest rate movement, affect the policies

and performance of all types of financial
institutions. For this reasons, it is critical for
managers of financial institutions to
understand why interest rates change, how
movements affect performances, and to
manage according to anticipated
movements.
8
2- Loanable Funds Theory:
a) The demand and supply of loanable:

The loanable funds theory (the loanable

funds market) commonly used to explain
interest rate movements, suggests that the
market interest rate is determined by the
factors that control the supply of and
demand for loanable funds and, so, the
demand and supply concepts are integrated
to explain interest rate movements.
9
a) The demand for loanable funds:
"Demand for loanable funds" is a widely used phrase
in financial markets pertaining to the borrowing
activities of households, business, and governments.
* Household Demand for Loanable Funds
Household commonly demand loanable funds to finance
housing expenditures, in addition, they finance the
purchases of automobiles and households items which
results in installment debt. There would be an inverse
relationship between the interest rate and the quantity of
loanable funds demanded. This simply implies that at any
point in time, household would demand a greater quantity
10
of loanable funds at lower rates of interest.
The negative relationship between the
demand for loanable funds and the
interest rate
P

(-ve)

Dh

D. For loanable funds

11
* Business Demand for Loanable Funds
Business demand loanable funds to invest in long-term
(fixed) and short-term assets. The quantity of funds
demanded by business depends on the number of
business projects to be implemented. Businesses
evaluate a project by comparing the present value of its
cash flows to its initial investment.

Projects with a positive net present value (NPV) are

accepted because the present value of their benefits
outweighs the cost. The required return to implement
projects will have positive NPVs , and a greater amount of
financing is required, this implies that businesses will
demand a greater quantity of loanable funds when
interest rates lower, as illustrated in the following
12
figure.
Relationship between interest rate and
business demand for loanable funds
of a given point in time (-ve)

(-ve)

Db 13
* Government Demand for Loanable Funds:
Whenever a government's planned expenditures
cannot be completely covered by its incoming
revenues from taxes and other sources, it
demands loanable funds, by issuing bonds and
treasury securities which represents government
debt.

Like the household and business demand. The

government demand for loanable funds can shift
in response to various events, and this will lead
to a shift in Dg2 at any level of interest rate, at it
is shown in the following figure: 14
Impact of increased Government Budget
Deficit on Government Demand (Dg)
for loanable funds

Dg1 Dg1
P

Dg
15
* Aggregate Demand for Loanable Funds:

The aggregate demand for loanable funds in the

sum of the quantities demanded by the separate
sectors at any given interest rate. because most
of these sectors are likely to demand a larger
quantity of funds at lower interest rates, (other
things being equal), the aggregate demand for
loanable funds is inversely related to interest
rates at any point in time. It the demand schedule
of any sector should change, the aggregate
demand schedule will be affected as well.
16
The negative relationship between
demand for loanable fund
and interest rates

DA

QLF
17
b) Supply of Loanable Funds :

Supply of loanable funds is a commonly used

term to represent funds provided to financial
markets by savers. The household sector is the
largest supplier, but loanable funds are also
supplied by some government units that
temporarily generate more tax revenues than they
spend or by some business whose cash inflows
exceed outflows. Households as a group,
however, represent a net supplier of loanable
funds, whereas governments and businesses are
net demanders of loanable funds. 18
Suppliers of loanable funds are willing
to supply more funds if the interest
rate is higher, other things being equal.
A supply of loanable funds exists even
at a very low interest rate, because
some household choose to postpone
consumption until (laster years, even
when the reward (interest rate) for
saving is low.
19
The aggregate supply schedule of counable
funds represents the combination of all
sectors supply schedules along with the
supply of funds provided by the "Monetary
Policy". The steep slope of the aggregate
supply schedule in the shown figure,
indicates that it is interest-inelastic, or
somewhat insensitive to interest rates. The
quantity of loanable funds demanded is
normally expected to be more sensitive to
interest rate than the quantity of loanable
funds supplied. 20
 The Aggregate supply of money in
loanable fund market

SA
P

Q. of loanable funds
21
c) Equilibrium Interest Rate:

When combining the aggregate demand

and aggregate supply schedules of
loanable funds, it is possible to compare
the total amount of funds that would
demand to the total amount of funds that
would be supplied at any particular interest
rate. The following figure illustrates the
combined demand and supply schedules.

22
 Interest Rate Equilibrium

SA
p

pe

DA

G. of Loanable Funds

23
At the equilibrium interest rate of (pe), the supply of
loanable funds is equal to the demand for loanable
funds.

• At any interest rate above (pe), there is a

surplus of loanable funds, interest rates will fall
until the quantity of funds supplied no longer
exceeds the quantity of funds demanded.

• At any interest rate below (pe), these will be a

shortage of loanable funds, interest rate will rise
until an additional supply of loanable funds is
available to accommodate the excess demand.
24
3- The Fisher Effect:

More than 50 years ago, Irving Fisher proposed

of interest rate determination that is still widely
used today. Fisher proposed that interest
payment compensate savers in two ways:

First: They compensate for a saver's reduced

purchasing power.

25
Second: They provide an additional premium to savers
for foregoing present consumption. Savers are
willing to pergo consumption only if they
receive a premium on their savings above the
anticipated rate of inflation, as shown in the
following equation:

N(r) = E() + R(r)

where:
N(r) = nominal or quoted rate of
interest
E() = expected inflation rate
26
R(r) = real rate of interest
This relationship between interest rates and
expected inflation is often referred to as a 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. These equation can be rearranged to
express the real rate of interest as:

R(r) = N(r) – E()

27
If the normal interest rate was equal to the expected
inflation rate, the real interest rate would be zero. So,
the purchasing power of savings would remain stable.

• If today's expected inflation can be measured along with

today's nominal interest rate, the ex ante real interest rate
can be estimated. The term ex ante means before the fact.
Our discussion focuses on expected inflation rather than
actual inflation.

• Because the inflation rate is difficult to estimate, the ex ante

real interest rate is difficult to measure. The actual inflation
rate that has occurred can serve as an imperfect substitute
for the expected inflation when monitoring the real interest
rate over time. If the actual inflation rate is used, the ex past
(after the fact) real interest rate is measured.28
29