FIN/366

One of the topics discussed this week was interest rates and how they are determined. This is a subject I have never given much thought to and didn’t have slightest idea of how interest were determined. There are many factors that affect interest rate movements.

Loanable Funds Theory

The loanable funds theory is one theory used to explain interest rate movements. The theory says that interest rates are determined by the demand and supply for loanable funds by households, businesses, and governments.

The factors looking for loanable funds such as businesses and households are more interested and likely to borrow money when interest rates are low. Though businesses will likely borrow money regardless depending on pending projects and other needs. Households will tend to hold off until interest rates lower to borrow money. Governments are interest-elastic which means they are not affected by interest rates. Foreign governments are also impacted by US interest rates because their interest in borrowing depends on whether the U.S. interest rate is lower than their own.

Supply of loanable funds works completely different. Suppliers are more likely to supply money when interest rates are high. Money is always available for households and businesses to borrow even when interest rates are low because some buyers wait until rates are low to purchase. The supply comes from households, businesses, and governments who purchase domestic securities.

Federal Reserve System

Interest rates are also affected by monetary policies enforced by the Federal Reserve System. The fed attempts to control the supply of loanable funds in order to control the economic conditions. By influencing interest rates the fed controls how much businesses and households are willing to borrow and spend. When the market crashed back in 2008 interest rates were purposefully dropped in order to encourage consumers to borrow and spend money to help stimulate the American economy.

Conclusion

The supply and demand of loanable funds are what causes interest rates to move. The demand by households, businesses, governments, and even foreign demand influences the rise or drop to interest rates. When rates are low consumers are more likely to borrow money. When rates are high suppliers of loanable funds are more likely to supply money for consumers. This money comes from not only domestic investors, but from foreign investors as well. Additionally the federal reserve also attempts to control the U.S economy by influencing consumer behavior and interest rates. There are many factors that influence the movements of interest rates.