Determination of interest rates:

In this section we discuss the theory of interest rates and their determination. We cannot discuss financial markets without bringing in a discussion about interest rates. Interest rates are the basic price in financial markets. We basically focus on a specific type of interest rate that can serve as the benchmark for other rates. This is the short-term riskless real interest rate. By real rate is meant the rate of interest adjusted for inflation. Subsequently, especially in the next section, we will discuss other types of interest and see how these are related to this basic interest rate. This is what is called the structure of interest rate. We will look at the factors that influence the yield on bonds.

To theoretically understand the determination of interest rates, we must examine the saving-consumption decision. Saving reflects primarily the choice between current consumption and future consumption. To understand this choice, we must think back to basic microeconomic theory and think, as was the case in simple theory of the consumer, of preferences and opportunity. In basic consumer theory, preference was represented by indifference curves and opportunity by the budget constraint. We can think of indifference curves in this context as well: the only difference is to depict, instead of two goods diagrammatically, we can think of 'consumption today' (consumption in the current period) and 'consumption tomorrow' (consumption in the next period). Consumption tomorrow' or deferred consumption is nothing but saving. We can draw indifference curves as well. Here too the  indifference curves will be convex to the origin, because as the consumer gives up successive equal amounts of current consumption, it will take higher and higher quantities of future consumption to make up for the loss of an additional unit. We can  draw a tangent at any point on the indifference curve, with the slope of the tangent showing the marginal rate of substitution between current and future consumption. Irving Fisher, the great American economist who pioneered the microeconomic analysis of interest rates, called it the marginal rate of time preference. It measures how many additional units of consumption tomorrow have to be given to the consumer to compensate for the loss of one unit of consumption today.

We now need to combine preferences with opportunities available to the consumer. Let us assume that the consumer is endowed with a certain given combination of consumption today and consumption tomorrow. Let us further assume that here is a loan market where this consumer is free to lend or borrow at a fixed exchange rate of  R =1+r and be able to exchange his initial or  current endowment for a different one. Let P be the amount lent, and let r be the interest. Then A =P(1+r) is the amount returned. Dividing by P, we get A/P = 1+r. This A/P is RLet or The opportunity locus (also called the market line) can be represented by a  downward sloping straight line that is just like the budget constraint in standard consumer theory. The consumer's initial endowment of combination of consumption in the current and subsequent period can be represented by a point on the  opportunity locus. To this line we add the family of indifference curves. There will be one curve that will be tangent to the market line. The consumption basket corresponding to this point of tangency can be shown to be the preferred one among all available  ones, given the market line, and hence it will be the chosen one. This is the point of equilibrium. Thus the possibility of borrowing and lending at the given rate allows the consumer to reach a higher indifference curve. At the equilibrium point, the marginal rate  of substitution is equal to the market rate. in a perfect market, everybody is confronted with the same market rate r, at equilibrium everybody has the same marginal rate of substitution. For simplicity, we have taken r as given, but demand and supply of funds  will determine r in a market economy. For a given R, each person will decide her consumption- saving pattern. In a simple  economy, deferred consumption, or saving, is the same as lending. By aggregating the net lending of each person who saves, for each R, we can get a supply curve of loans which will be an upward sloping function of R.