As a practical matter, we need to divide interest rates into short-term interest rates—those where the principle must be repaid in one year or less—and long-term interest rates—those where the principle must be repaid over a period in excess of one year. Some short-term interest rates include credit cards, treasury bonds with maturity of less than one year, business or personal lines of credit, and corporate paper loans. Long-term interest rates include automobile loans, home mortgages, student loans, and home equity lines of credit.
Interest rates, both short- and long-term, are ultimately determined like any good or service; that is, by the laws of demand and supply. The equilibrium interest rate and equilibrium quantity of loans borrowed is determined by the intersection of demand for loans and supply of loans. The graph below calls the good we are examining financial capital. It is often also called the demand and supply of loanable funds or the demand for and supply of loans.
Figure 7.3. The United States as a Global Borrower Before and
After U.S. Debt Uncertainty by Steven A. Greenlaw and David
Shapiro is used under a CC BY 4.0 License.
We can see who creates the demand for loans and the supply of loans by using a simple model known as the circular flow of the economy. Households supply labor to firms and receive wages in return. Firms produce goods and services by using labor along with the plants and equipment they own (physical capital), as well as natural resources and raw materials (sometimes called “land”). Firms then sell these goods and services to households (consumption spending). Households spend some of their disposable income and save some of it:
Households put their savings into banks or stocks or bonds, therefore:
The savings that households deposit in banks are the Supply of Loanable Funds.
Figure 7.4. Market for Loanable Funds
Households supply Loanable Funds to banks through deposits. How much Loanable Funds households supply is determined by the price they will be paid for their savings (the interest rate) and other factors, such as how much income they make. Firms, households and the government demand Loanable Funds. The price of Loanable Funds and other factors, such as the state of the economy, determine how large the demand is. Banks are the intermediaries, who collect the deposits and lend them out to the borrowers, adding a markup, of course, to cover their overhead and to create a profit for their stockholders.
Figure 7.5. The Three-Sector Economy Model by North Broad Press adapts Owning a Home, Bank Account, Government Building, and Ciudad (by Ecelan) and is used under a CC BY-SA 4.0 License.
In general, financial intermediaries are in business to make a profit. While this is not true of credit unions, they still have to pay interest to their depositors, cover their workers’ wages, and fund overhead; they just do not have to make money above their expenses to pay to stockholders. In any case, financial intermediaries supply banking services. As a producer of banking services, we can characterize their production function like any other firm:
For any firm, the definition of profit is:
For financial intermediaries, their total revenue is the interest they earn on the loans they make plus some investment returns (usually Treasury Bonds). Their costs are the interest they pay their depositors, interest on Commercial Paper, physical capital expenses, and employee wages. Thus, a financial intermediary defines profit as such:
To cover all its expenses, the financial intermediary must decide what breakeven interest rate it must charge on its loans. In order to understand this, we can think of interest rates as having three components:
- A Risk Premium
- Expected Inflation
- The Time Value of Money
Let’s imagine you are going to throw a party for all your friends. You have saved $1,000 and have exactly enough money to buy 20 kegs at $50.00 apiece. A couple of weeks before the party, your best friend says his car broke down, and he really needs it for work. It will cost $1,000 to fix it, and he asks you to lend him $1,000.00 and promises to pay you back within one year with interest. Tough call, right? It is your best friend, of course, so you lend him the money for one year. But what interest rate should you charge? Let’s examine the components.
First, you are giving up using your $1,000 for the party (Consumption), and you deserve some interest payment. This is known as the time value of money. The time value of money over the long term has historically been 2 to 3% (a rate we have seen on long-term loans when there is no inflation).
Second, when you get the $1,000 back, you want to still be able to buy 20 kegs of beer. If the cost of the kegs has inflated, you want the principal amount you lent to still be worth $1,000, so you want the future or expected inflation rate to be applied to the principal. Let’s say this is 2%.
Finally, there is a risk premium on top of all this. Let’s say you expect your friend to only pay back 95% of the principal. You want to be made whole, so you charge this risk premium of 5% on top of the other two components. This part of the analogy does not work as well, but in real-world banking, if you have $1,000,00 in loans outstanding and historically 5% of the loans default, you have to get that 5% back first before you can start earning on your money. If we add these components all together, you would charge your friend 9% for a one-year loan of $1,000.
- A Risk Premium: 5%
- Expected Inflation: 2%
- The Time Value of Money: 2%
Figuring this all out can be mentally exhausting, so financial intermediaries use a shortcut. U.S. Treasury Bonds are considered the safest investment in the world, so the U.S. is charged an interest rate that includes only the time value of money plus expected inflation. For example, let’s say a ten-year U.S. Treasury Bond pays an annual interest of 4%. Since we know the time value of money is 2%, these must be the components of that 4% interest rate:
- A Risk Premium: 0%
- Expected Inflation: 2%
- The Time Value of Money: 2%
As a shortcut, financial intermediaries look at the market interest rate on the appropriate term length U.S. Treasury Bond and match it to a loan they are making with the same term length and add a risk premium. Let’s look at the current rates for Treasury Bills, Treasury Notes and Treasury Bonds. The maturity of a Treasury obligation is its term; that is, when the principal amount will be paid back in full.
- Treasury Bills mature in one year or less.
- Treasury Notes mature in two to ten years.
- Treasury Bonds mature in longer than ten years.