Finance: Capital Markets, Financial Management, and Investment Management

CHAPTER 5

Interest Rate Determination and the Structure of Interest Rates

Market participants make financing and investing decisions in a dynamic financial environment. They must understand the economy, the role of the government in the economy, and the financial markets and financial intermediaries that operate in the financial system. We have described the financial system in the previous chapter. Now we focus on a critical aspect of the financial environment that affects financial decisions: interest rates. We begin with two economic theories about the determinants of the level of interest rates and then discuss the role of the U.S. Federal Reserve System in influencing interest rates. Finally, because there is not one interest rate in an economy but a structure of interest rates ,we describe the factors that affect the structure of interest rates. We conclude the chapter with economic theories about the term structure of interest rates (i.e., relationship between interest rates and the maturity of debt instruments).

THEORIES ABOUT INTEREST RATE DETERMINATION

There are two economic theories of how the level of interest rates in an economy are determined:

• Loanable funds theory

• Liquidity preference theory

We describe both in this section.

Loanable Funds Theory

In an economy, households, business, and governments supply loanable funds (i.e., credit) in the capital market. The higher the level of interest rates, the more such entities are willing to supply loan funds; ...