CREDIT MARKETS. THE BEST DESCRIPTION OF THE CREDIT MARKET!
. Horace Brock: "Determinants of interest rates", Euromoney (*)

An ‘extended’ law of supply and demand
How do we analyze the determinants of interest rate movements in today’s deregulated, globalized environment? What paradigm is most appropriate? We shall argue that the complexities of today’s environment require that we analyze interest movements in what can be called an ‘extended’ law of supply and demand in the credit market. Although this approach is both theoretically correct and intuitively appealing, it is surprisingly unfamiliar to market participants as well as to many who construct forecasting models.

Surprisingly, one reason this is true is that most people do not understand what the law of supply and demand means in a credit (as opposed to a money) market context. In this regard, shifts in credit supply and demand are often mistakenly identified with changes in economic flow-of-funds. In other instances, supply and demand considerations are incorrectly seen as incompatible with more important ‘psychological’ factors. This chapter will clarify the true meaning of supply and demand in today’s deregulated credit market. In doing so, it will demonstrate how the extended law of supply and demand is able uniquely to explain numerous dramatic events in credit markets.

The extended law of credit supply and demand
Exhibit 1 [not reproduced here] shows the working of today’s credit market. On the left are those who ‘lend’. Note that the central bank fits in here in a natural way via its open market activities that provide bank reserves to the banking system. As the diagram indicates, it is the banks that provide credit – not the central bank.

How do interest rates change within this framework? They change when the behavior of borrowers and lenders/investors changes. But what do we mean by a ‘change of behavior’? Understanding this concept is the key to everything. The ‘supply schedule’ here can be best thought of as the nation’s aggregate ‘willingness to lend’ schedule (foreign lending is included). This schedule depicts the total amount of funds that will be made available at any given nominal interest rate. Naturally, the higher the interest rate, the more credit will be made available, other things being equal. Hence the schedule has a positive slope. A parallel analysis holds for the demand schedule, although in this case the quantity demanded decreases as the price rises. Equilibrium occurs at the point of intersection of the two schedules.

Changes in interest rates
As the state of the world changes, the aggregate willingness to lend at any given interest rate (say € 500bn annually at a 5% interest rate) will change. It will either increase or decrease. For example, if inflation escalates, people might only be willing to lend € 400bn at the same 5% nominal rate. But as this decrease will be true for any and every level of interest rates, the entire schedule clearly shifts backward. It is this ‘functional shift’ (of the schedule) that causes interest rates to change.

Why do we emphasize this point? Because it is often misunderstood. For example, suppose you hear that ‘mortgage credit demand has increased’. Does this constitute a ‘change’ that will lead to an increase in interest rates? Not necessarily. If the increased demand is itself simply a response to a lower interest rates, then this increase represents a shift ‘along’ the given demand curve. It is only when demand is greater or lesser at a given interest rate that the entire schedule shifts, and this that interest rates can and do change.

(*) See also, on the loanable funds theory of interest-rate determination, Frank J. Jones & Benjamin Wolkowitz: "The Determinants of Interest Rates on Fixed Income Securities", in Frank J. Fabozzi (ed.) The Handbook of Fixed-Income Securities (Honwood, Ill.: Richard D. Irwin, 1991, pp. 141-179)