Chapter 6 Interest Rates 1656-2 INTEREST RATE LEVELS
Borrowers bid for the available supply of debt capital using interest rates: The
! rms with the most pro! table investment opportunities are willing and able to
pay the most for capital, so they tend to attract it away from inef! cient! rms and
! rms whose products are not in demand. Of course, the economy is not completely
free in the sense of being in" uenced only by market forces. For example, the fed-
eral government has agencies that help designated individuals or groups obtain
credit on favorable terms. Among those eligible for this kind of assistance are small
businesses, certain minorities, and! rms willing to build plants in areas with high
unemployment. Still, most capital in the United States is allocated through the
price system, where the interest rate is the price.
Figure 6-1 shows how supply and demand interact to determine interest rates
in two capital markets. Markets L and H represent two of the many capital mar-
kets in existence. The supply curve in each market is upward-sloping, which indi-
cates that investors are willing to supply more capital the higher the interest rate
they receive on their capital. Likewise, the downward-sloping demand curve indi-
cates that borrowers will borrow more if interest rates are lower. The interest rate
in each market is the point where the supply and demand curves intersect. The
going interest rate, designated as r, is initially 5% for the low-risk securities in Mar-
ket L. Borrowers whose credit is strong enough to participate in this market can
obtain funds at a cost of 5%, and investors who want to put their money to work
without much risk can obtain a 5% return. Riskier borrowers must obtain higher-
cost funds in Market H, where investors who are more willing to take risks expect
to earn a 7% return but also realize that they might receive much less. In this sce-
nario, investors are willing to accept the higher risk in Market H in exchange for a
risk premium of 7%! 5% " 2%.
Now let’s assume that because of changing market forces, investors perceive
that Market H has become relatively more risky. This changing perception will in-
duce many investors to shift toward safer investments—along the lines of the re-
cent “" ight to quality” discussed in the opening vignette to this chapter. As inves-
tors move their money from Market H to Market L, this supply of funds is increased
in Market L from S 1 to S 2 ; and the increased availability of capital will push down
interest rates in this market from 5% to 4%. At the same time, as investors move
their money out of Market H, there will be a decreased supply in that market; and
tighter credit in that market will force interest rates up from 7% to 8%. In this new
Interest Rate, r
(%)rL = 5
40 Dollars 0Market L: Low-Risk Securities Market H: High-Risk SecuritiesDS (^1) S 2
Interest Rate, r
(%)
rH = 7
8
Dollars
D
S (^2) S
1
Interest Rates as a Function of Supply and Demand for Funds
F I G U R E 6! 1