3 - The term structure of interest rates and financial markets

Abstract

The term structure of interest rates or maturity structure refers to the set of theories designed to explain why practically homogeneous bonds of different maturities have different interest rates. Interest rates are prices. Unlike other prices, they are usually expressed as percentages of the amount borrowed or lent. But, like other prices, they are determined by supply and demand. Interest rates depend on the supply of and the demand for funds that can be given as loan. The sources of the supply of funds are savings, reductions in the demand for money and increase in the supply of money. The sources of the demand for funds are investment demands, consumption demands (for spending on consumer goods), and increases in the demand for money. In equilibrium, the interaction between the demand for loanable funds and the supply of loanable funds determine the interest rate. The effect on the interest rate of any shift in demand or supply depends on the elasticity of both supply and demand. Following a change in demand, the less elastic (more elastic) is the supply curve the more (less) will be the change in interest rates. Following a change in supply, the less elastic (more elastic) is the demand curve the more (less) will be the effect on interest rates.