Topic 9 - An Introduction To Interest Rate Determination

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This article is a topic within the subject Capital Markets and Institutions.


Required Reading

Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 442-479.

Macroeconomic Context of Interest Rate Determination

[1] In most developed economies, monetary policy is directly aimed at influencing interest rates. By understanding what causes central banks to alter policy allows financial market participants to anticipate changes (in policy) & allow lenders & borrowers to make better informed decisions. A central bank may increase interest rates if; excessive inflation, excessive growth in GDP, CAD deficit, excessive growth in debt & credit levels & excessive depreciation in the domestic currency. The flow on effects will be; an eventual increase in long term rates, slower consumer spending (lower inflation & imports), an improvement in the CAD & an increased amount of foreign investment inflows causing an appreciation in the currency.

The 3 effects of changes in interest rates are:

  1. Liquidity Effectaffect of the RBA’s market operations (CGS’s, Repo’s, Currency Swaps)on money supply & system liquidity
    • Increase rates by selling CGS’s (tightening)
  2. Income Effectis a flow on effect from the initial liquidity effect on interest rates
    • Rising interest rates - lower spending/income, slowing economic activity, loan demand falls allowing rates to ease
  3. Inflation Effectas the rate of growth in economic activity (income, loan demand & spending) slows, CPI falls
    • This results in an easing of the rate of inflation & interest rates

It is difficult to forecast the extent of the liquidity, income & inflation effects on changes in interest rates (particularly if the business cycle changes). Economic indicators are used to help forecast future economic growth & central bank intervention.

  • Leading Indicators – economic variables that change before the business cycle e.g. housing loan approval
  • Coincident Indicators – economic variables that change at the same time as the business cycle e.g. industrial production
  • Lagging Indicators – economic variables that change after the business cycle e.g. unemployment rate

However, the extent of the timing lead or lag of indicators is unclear & consistently performing indicators e.g. rates of growth in money measures were once lead indicators & are now lagging indicators.


Loanable Funds Approach To Interest Rate Determination

[3] The Loanable Funds (LF) approach is the preferred way of explaining & forecasting interest rates as it is a conceptually simplistic model & is preferred by analysts. In contrast, the macroeconomic view uses the demand & supply of money to explain rates, while the Loanable Funds approach uses the supply of & demand for loanable funds.

Demand For Loanable Funds

Loanable Funds refers to funds available in the financial system for lending. The demand (downward sloping) for LF’s is from;

  • Business (B)requires short term working capital & long term capital investment
  • Government (G)finance budget deficit & intra-year liquidity (the public sector borrowing requirement) – independent of the rate of interest as government expenditures are not discretionary once committed. Surpluses are represented in savings in the supply curve.


Supply Of Loanable Funds

The supply (upward sloping) of Loanable Funds is sourced from 3 places:

  • Household Savings (S)as rates increase, MPS’s increase (increases in rates only causes a small increase in savings - steep)
  • Changes in Money Supply (/_\ MS)(independent of the interest rate – S + Changes in MS = Parallel to Savings)
  • Dishoarding (D)dishoarding occurs (currency holdings decrease) as interest rates rise & more securities are purchased for the higher yield available. (At low rates, Supply = S + C in MS – H). It stops once portfolio reallocation is complete.
    • Hoarding is the proportion of total savings in an economy held as currency

The Equilibrium


The equilibrium in the LF market is at point E. However, ‘E’ is a temporary equilibrium as supply & demand are not independent, changes in supply effect demand. Furthermore, the level of dishoarding will inevitably change (a certain level cannot continue indefinitely), the money supply is unlikely to increase proportionately in subsequent periods & business demand will increase if rates fall while the government may go into surplus if the economy grows (also increased savings from higher incomes. Other impact disturbances on rates include:

  • Expected Increase in Economic Activity - firms sell securities (raise funds to meet increased demand), prices fall & yields increase, dishoarding occurs increasing supply (temporarily), growth increases incomes & savings & government surpluses
  • Inflationary Expectations - Demand increases (firms invest now), supply shifts to the left (demand higher rates)
    • Non Fisher Effectdemand does not increase as much, as tax receipts rise faster than expenses = a smaller deficit or greater surplus budget, increase in supply due to dishoarding (eroding currency values) & savings increase due to uncertainty (superannuation savings rise at inflation – contractual savings) – rates don’t rise as much

Term Structure Of Interest Rates

[6] Yield refers to the total return on an investment (interest & capital gains). The Yield Curve is a graph, at a point in time, of yields on an identical security (same risk category) with different terms to maturity. Different shaped yield curves occur:

  • Normal/Positivelonger term rates higher than short term rates (upward sloping)
  • Inverse/Negativeshort term rates higher than long term rates (downward sloping)
  • Humpedrates change over time from normal to inverse or vice versa

As the yield curve changes over time, monetary policy interest rate changes are not the only factor affecting interest rates.

Expectations Theory

The current short term interest rate & expectations about future short term interest rates are used to explain the shape & changes in shape of the yield curve. This theory is based on a number of assumptions:

  • Large number of investors with homogenous expectations (economy’s fundamentals/CB policy) of future short term rates
  • No transaction costs (move in & out) or impediments to interest rates moving to their competitive equilibrium levels
  • Investors aim to maximise returns & view all bonds as perfect substitutes regardless of term to maturity

Longer Term Rates are equal to the Average of the Short Term Rates expected over the period.

  • Normalexpected future short term rates are higher than current short term rates
  • Inverseexpected future short term rates are lower than current short term rates
  • Humpedexpected future short term rates to rise in the future but to fall in subsequent periods


The rate on a 1 year instrument is 7% & the expected rate on it in 1 years time is 9%, the current 2 year rate is 8% or 7.99% (Geometric Average).

Market Segmentation Theory

Assumes securities in different maturity ranges are viewed by market participants as imperfect substitutes, (investors prefer to operate within some maturity range). This is because participants try to reduce risk (minimise exposure to fluctuations in prices/ yields) thus rejecting 2 assumptions of expectations theory (bonds are perfect substitutes & investors are indifferent between short or & long term maturity instruments).

The shape & slope of the yield curve is determined by the relative demand & supply of securities along the maturity spectrum


  • Central Bank Sells Short Term Securities - decrease in price, increase in yield (left diagram)
  • Central Bank Sells Long Term Securities - decrease in price, increase in yield (right diagram)

If the central bank increases the average maturity of bonds by purchasing short term bonds & selling long term bonds

  • Segmented Theory – short term yields fall & long term yields rise, financial system liquidity unchanged but expansion (contraction) in areas of expenditure sensitive to short (long) term rates.
  • Expectations Theory – no effect on expectations about future short term interest rates & therefore no effect on economy

Liquidity Premium Theory

Assumes investors prefer short term instruments, which have greater liquidity & less maturity, interest rate & default risk & therefore investors require compensation for investing long termthe liquidity premium. This is true because longer term bonds are more susceptible to large price fluctuations (more discounting periods). Liquidity premium & expectations theory combined:


Expectations Vs. Segmentation Theory

  • Segmentation has a too narrow emphasis on risk management as a motivation of participants
    • Denies the existence of arbitrageurs – without their participation there would be discontinuities in the yield curve
    • Denies existence of speculators who trade based on expectations to make speculative profit
  • Segmentation does not explain the relationship between monetary policy settings & the shape of the yield curve
  • Expectations is more correct in saying that investors aim to maximise profits, especially with rise of risk mgmt products

If the RBA buys long term bonds, yields fall & short term rates are unaffected (segmentation theory). If the yield curve was reasonably flat before, the long end will be lower with no change in the short end – this is unrealistic as arbitrageurs would sell long term bonds & simultaneously buy the higher yielding short term securities causing their prices to rise & yields to fall resulting in the central banks actions being transferred through the length of the yield curve.[9]

Risk Structure Of Interest Rates

[10] Default risk is the risk that the borrower will fail to meet interest payment obligations. Commonwealth government bonds are deemed to have 0 default risk (risk free rate of return), other borrowers will have a greater risk of default & investors will require compensation for bearing the extra default risk. This risk (& compensation) changes over time.



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Textbook refers to Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill.

  1. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 444-448
  2. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  3. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 448-456
  4. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  5. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  6. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 456-465
  7. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  8. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  9. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  10. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 465-468
  11. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
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