FINANCIAL MARKETS: ANSWER WITH NO PLAGIAR. Question 3 As the treasurer of a manufacturing company, your task is to forecast the direction of interest rates. Your company plans to borrow funds and it may use the forecast of interest rates to determine whether it should obtain a loan with a fixed interest rate or a floating interest rate. The following information can be considered when assessing the future direction of interest rates; . Economic growth has been high over the last two years, but you expect that it will be stagnant over the next year. . Inflation has been 3 percent over each of the last few years, and you expect that it will be about the same over the next year. The federal government has announced major cuts in its spending, which should have a major impact on the budget deficit. . The Federal Reserve is not expected to affect the existing supply of loanable funds over the next year. . The overall level of savings by households is not expected to change. Questions: 1) Given the preceding information, assess how the demand for and the supply of loanable funds would be affected (if at all), and predict the future direction of interest rates, 2) Your company can obtain a one-year loan at a fixed-rate of 6 percent or a floating-rate loan that is currently at 8 percent but its interest rate would be revised every month in accordance with general interest rate movements. Which type of loan is more appropriate based on the information provided?

1. Interest rates will likely go down next year given that the demand for loanable funds will likely drop amid a stable supply.

2. Given the likely downtrend in interest rates next year, it would likely be better to take a loan based on a floating interest rate.

Step-by-step explanation

1. Interest rates will likely go down next year given that demand for loanable funds will likely drop amid a stable supply.

• To determine the trend in interest rates in the following year, you have to first understand the forces that affect the level of interest rates.
• It is very much like your aggregate demand and supply curves only this time the market is for loanable funds.
• You can then start by classifying each of the factors given above and see how they will affect the demand and supply for loanable funds.
• Stagnant economic growth would mean no increase in demand for loans -- no change in demand for loanable funds
• Inflation remaining at the same level next year implies the Fed does not have to tighten money supply or the supply of loanable funds. -- no change in supply of loanable funds
• Lower government deficit would mean the government would not be borrowing from the domestic market -- decrease in demand for loanable funds
• Fed committed to keep supply of loanable funds stable -- no change in supply of loanable funds 
• Household savings to remain unchanged -- no change in supply of loanable funds
• Note that while supply for loanable funds will likely remain the same, the demand for them will likely decrease due to lower government borrowings. That is, the government will not be crowding out the private sector for loans and will thus push down interest rates.
• The net effect of all the events given above will thus be a decrease in the demand of loanable funds. Amid a steady supply of loanable funds, interest rates are thus likely to decrease.

2. Given the likely downtrend in interest rates next year, it would then be better to take a loan based on a floating interest rate.

• Simply put, if the general interest rate goes down, the interest rate you have to pay will also drop, thus saving your company on interest costs.