Money and Interest Rates

10 Key excerpts on "Money and Interest Rates"

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  eBook - PDF

  Fundamentals of Finance

  Investments, Corporate Finance, and Financial Institutions

  • Mustafa Akan, Arman Teksin Tevfik(Authors)
  • 2020(Publication Date)
  • De Gruyter

    (Publisher)

  Money supply has various definitions as M1, M2, and M3. Economists believe that the money supply is important in managing economic activity. The interest rate is the cost of money. For banks, interest is paid on savings de-posits; to consumers, interest is paid on loans and credit card balances. Interest can also be defined as the cost of postponing consumption. The nominal interest rate (NIR) is subject to risks of inflation, maturity, default, and liquidity. The yield curve plots yield against time to maturity for default-free securities. 6 For a complete discussion of bank regulation, see S. Dow, “ Why the banking system should be Regulated, ” Economic Journal , 106(436), 1996, pp. 698 – 707. 2.11 Summary 29 The Central Bank in general is a government-established organization responsi-ble for supervising and regulating the banking system and for creating and regulat-ing the money supply. The balance sheet of a Central Bank is an important economic indicator followed by markets. The banking industry is heavily regulated to inform investors properly, insure soundness of financial intermediaries, and improve monetary control. 30 2 Money and Interest Rates

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  Applied International Economics

  • W. Charles Sawyer, Richard L. Sprinkle(Authors)
  • 2020(Publication Date)
  • Routledge

    (Publisher)

  S o far, we have examined the institutional details of the foreign exchange market and explained what determines the exchange rate. The model of exchange rate determination developed in the previous chapter explains some of the movement in exchange rates. Both the rate of inflation and the growth rate of GDP usually do not change dramatically over short periods of time, such as one day to the next. Yet, exchange rates change almost every minute of every business day. As a result, we need to expand our model of exchange rate determination to include another factor that determines or influences exchange rate movements over short periods of time. This factor is short-term interest rates. Since interest rates have an important influence on the exchange rate, we need to describe what causes domestic interest rates to change. In the first part of the chapter, we will review and expand on what you learned in your Principles of Economics course concerning the supply and demand for money and the determination of the equilibrium interest rate within a domestic economy.

  In the second part of the chapter, we will examine the relationship between interest rates and the exchange rate. As we will see, any change in interest rates will lead to changes in the inflows and outflows of capital in a country’s financial account and the changes in capital flows lead to changes in the exchange rate. By the end of the chapter, we will be able to examine how changes in interest rates, the exchange rate, the current account, and the financial account all interact with one another.

  MONEY DEFINED: A REVIEW

  When trying to determine how money affects the exchange rate, our first objective is to define the term money. Most individuals believe that they know what money is, but in fact, what constitutes money is not clear at all. The easiest way to describe money is to consider what it does. Money has to perform three separate but important functions. First, it must act as a medium of exchange. This is money’s most important function. How would economic transactions be conducted in a world without money? Without money, every price would be a relative price. For example, the price of a hamburger would be defined as what a hamburger is worth in terms of all other goods and services. In an advanced economy with a large number of goods and services, this relative pricing quickly becomes untenable. The price of one hamburger might be defined as four soft drinks or .04 tires. No one could possibly keep track of all the possible relative prices. The power of money is largely dependent on solving this relative-price problem. If there are 50,000 goods in any economy, there are only 50,000 prices. This is complicated but the alternative is far more complicated. Even if governments did not produce money, some item would emerge as a medium of exchange. In anything other than the simplest economy, something would emerge to serve as money.1

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  Money and Banking

  Made Simple

  • Ken Hoyle(Author)
  • 2014(Publication Date)
  • Made Simple

    (Publisher)

  An increase in the quantity of money might reduce the rate of interest—as money became less attractive than other financial assets—but it was also, through the lower rate of interest, likely to stimulate the level of business investment. As business investment pushed ahead of saving, money incomes would rise, prices rise, and the level of money balances required would also rise. The rate of interest would return to its former level (or something close to it). In fact, in the theoretical state of complete equilibrium—that is, equilibrium in commodity, factor and money markets—the rate of interest which gives equality between the demand for and supply of money (monetary approach) will also be that rate which gives equilibrium between savings and investment (real approach). This must be the case otherwise there could be no complete equilibrium: there would still be movement in one of the markets which would lead to further variation in national income. Since there can only be one equilibrium rate of interest for each level of income theoretically possible within an economy, adjustment would take place in all markets until a single, equilibrium, rate of interest is reached. We may therefore conclude as follows: (i) The rate of interest is the price for money—the rate which governs the demand for and supply of money. (ii) It is possible to use two distinct and seemingly conflicting approaches 104 Money and Banking to the determination of interest rates. One of these, the 'real' theory of interest rates, stresses the importance of real factors—thrift and the productivity of investment. The other 'monetary' theory of the rate of interest stresses the importance of the desire to hold money as a good in its own right. (iii) In reality, the two approaches are not as incompatible as they first appear. In the final analysis there can only be one equilibrium rate of inter-est—that which balances all markets.

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  Money, Banking, Financial Markets and Institutions

  • Michael Brandl(Author)
  • 2016(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  Here we examine why this is the case and how difficult it actually is to measure the money supply. Finally, one thing we will come back to again and again is the “price of money.” One, but not the only, price of money is interest rates. We take a look at why interest rates exist and how they are used in calculating the value today of money we will receive in the future, as well as the value of money in the future that we have today. The changes in the price of money can have a large impact on just how fast, or slow, the economic world goes around and around. 2-1a Money Defined Whenever you begin studying a new concept, it is often best to start with a formal definition. A formal definition of money would read something like this: Money: Anything that is generally acceptable in exchange for goods and services and/or repayment of debt. What does that really tell us? First, notice it says “anything”; there is no mention that money has to come from the government or the central bank, or even from banks in general. Money is something that people “generally accept” in exchange for goods and services. Note that just because a government or central bank issues currency does not mean it will be accepted as money. For example, leading up to the Russian Ruble Crisis of 1999, people in Russia stopped using the official, government-issued ruble in exchange for goods and services. Thus the ruble was ceasing to be money because it was no longer “generally accepted” by the Russian people. Later in this chapter we look at how a wide variety of things, including vodka during the Russian Ruble Crisis, has functioned as money over time. At this point, don’t get hung up on the idea that money must be those little scraps of paper issued by the central bank that you are carrying around in your wallet. Remember, money is anything that is generally acceptable in exchange for goods and services and/or repayment of debt.

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  Money, Banking, Financial Markets & Institutions

  • Michael Brandl(Author)
  • 2020(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  Here we examine why this is the case and how difficult it actually is to measure the money supply. Finally, one thing we will come back to again and again is the “price of money.” One, but not the only, price of money is interest rates. We take a look at why interest rates exist and how they are used in calculating the today’s value of money we will receive in the future, as well as the value of money in the future that we have today. The changes in the price of money can have a large impact on just how fast, or slow, the economic world goes around and around. 2-1a Money Defined Whenever you begin studying a new concept, it is often best to start with a formal definition. A formal definition of money would read something like this: Money: Anything that is generally acceptable in exchange for goods and services and/or repayment of debt. What does that really tell us? First, notice it says “anything”; there is no mention that money has to come from the government or the central bank, or even from banks in general. Money is something that people “generally accept” in exchange for goods and services. Note that just because a government or central bank issues currency does not mean it will be accepted as money. For example, leading up to the Russian Ruble Crisis of 1999, people in Russia stopped using the official, government-issued ruble in exchange for goods and services. Thus, the ruble was ceasing to be money because it was no longer “generally accepted” by the Russian people. Later in this chapter, we look at how a wide variety of things, including vodka during the Russian Ruble Crisis, has functioned as money over time. At this point, don’t get hung up on the idea that money must be those little scraps of paper issued by the central bank that you are carrying around in your wallet. Remember, money is anything that is generally acceptable in exchange for goods and services and/or repayment of debt.

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  Monetary Economics

  Policy and its Theoretical Basis

  • Keith Bain, Peter Howells(Authors)
  • 2017(Publication Date)
  • Red Globe Press

    (Publisher)

  This stresses the narrow approach to defining money based on the point of view of the creditor and the idea of final settlement of debt. It is obviously important for indi-viduals to know what is acceptable in exchange but this is a matter of national, and sometimes local, practice and might change over time. People also need to know how easily and speedily, and at what cost, they can convert illiquid assets into money and how likely they are to be able to obtain liquid resources through borrowing. For none of this do people need either a formal definition of ‘money’ or an appreciation of how much 'money' exists in the economy. At an individual level, people are seldom prevented from engaging in the exchange of goods because of a lack of money in the sense that we are using it here, although they may be so prevented because of a lack of spending power or by the cost of bor-rowing against their assets or their expected future income. We have seen, however, that things may be different at an aggregate level. Much depends on whether we accept the notion that the authorities could and should operate on the interest rate by attempting to control the stock of money. In this case, we would need a clear idea of what constitutes the money supply and some ability to measure it. If, however, the authorities attempt to control spend-ing directly by adjusting the interest rate, we do not need to define or to measure 'money' even at an aggregate level. We might still choose to attempt to do so but only perhaps as one of a number of indicators of the desirability of adjusting the interest rate. The fact that we might only have a very limited and specific need for a definition of ‘money’ in economics may well influence the definition we use, The meaning of money 16 Pause for thought 1.6 Keynes is widely quoted as having said: ‘In the long run we are all dead'. Is this an accurate quotation? (Hint: check The Tract on Monetary Reform , 1923).

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  Macroeconomics

  An Introduction

  • Alex M. Thomas(Author)
  • 2021(Publication Date)
  • Cambridge University Press

    (Publisher)

  Generally, the speculative demand for money is low when the interest spread is high and vice versa. Or, simply put, if you assume that holding money earns zero interest, then we will hold money if the rate of interest on bonds is low and we will hold bonds if the rate of interest on bonds is high. Conversely, if the interest rate is high, the opportunity cost of holding money for transactions is high and, therefore, the transaction demand for money and the interest rate are also inversely related. Putting together the aforementioned factors which influence the demand for money, it can be concluded that the demand for liquidity (money) is determined by the volume of transactions and the cost of borrowing (interest rate). For simplicity, let us assume that the demand for money is linearly related to the rate of interest. This enables us to draw a straight line which slopes downwards from left to right (see Figure 3.4). Pay close attention to how we swiftly moved from an inverse relationship to a functional relationship of a linear nature. Think about and note down the various assumptions that have to be made when we mathematically translate the idea of an inverse relationship into a precise functional form. How is money supplied or, more accurately, created in the economy? There are two broad approaches to answer this question in the economics literature: ( a) exogenous money and ( b) endogenous money. As the names suggest, the first approach argues that money supply is given from outside the monetary production economy by the central bank, whereas the second approach argues that money is created inside the monetary production economy, particularly by the (private) banking sector, when responding to the economy’s demand for liquidity. Before we enter into the details of these approaches, let us depict the money demand and supply functions for both the approaches. Figure 3.4 Exogenous and endogenous money

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  Economic Analysis in Historical Perspective

  Butterworths Advanced Economics Texts

  • J. Creedy, D.P. O'Brien(Authors)
  • 2014(Publication Date)
  • Butterworth-Heinemann

    (Publisher)

  24 Monetary economics bridge between the modern literature and the comprehensive discus-sions of early years. 2.6.1 FOUNDATIONS OF INTEREST THEORY The importance of the rate of interest was recognized in the seven-teenth century. Locke believed changes in the rate to affect both trade and the value of money; and Sir Josiah Child of the East India Company argued strongly for a reduction in the rate from 6 per cent to 4 per cent, attributing superior Dutch performance in trade and growth to a low rate of interest in Holland 78 . In Mercantilist writings the rate of interest frequently appears as a purely monetary phenomenon. From the time of Hume, Massie and Smith there was insistence that the rate of interest was a real phenomenon, and it was equated with the marginal productivity of investment 79 . Both Thornton and Ricardo insisted that there was a real rate of interest, which could be identified as marginal profitabil-ity; and both writers, followed by many others, insisted that changes in the money supply produced only temporary variations in the market rate, which must ultimately equalize with the real rate. Thornton, and later Ricardo, pointed out that the distinction between the money and the real rate had important implications for Bank policy; there was no limit to the amount which the Bank could lend if the money rate were less than the real rate. Thornton was particularly clear on this. He also distinguished between the nominal and the deflated rate of interest, and expressed the view that nominal rates will adjust during persistent inflation to cover the loss of principal 80 . This analysis provided the foundation for the discussion in the era of the Bank Charter Act, the period in which the Bank of England began to use Bank Rate as a policy weapon 81 . Both Banking and Currency School writers treated the natural rate of interest as the net profit on capital after allowance for risk and trouble of employment.

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  CFIN

  • Scott Besley, Eugene Brigham, Scott Besley(Authors)
  • 2021(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  115 CHAPTER 5: The Cost of Money (Interest Rates) Copyright 2022 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 3. When the U.S. economy shows signs of expanding too quickly, the Fed normally takes actions to increase interest rates to discourage too much expansion and to control future growth so that it does not result in high inflation. 4. During recessions, short-term rates decline more sharply than do long-term rates. This situation occurs for two reasons. First, the Fed operates mainly in the short-term sector, so its intervention has the strongest effect here. Second, long-term rates reflect the average expected inflation rate over the next 20 to 30 years. This expecta- tion generally does not change much, even when the current rate of inflation is low because of a recession. 5-5 INTEREST RATE LEVELS AND STOCK PRICES Interest rates have two effects on corporate profits. First, because interest is a cost, the higher the rate of inter- est, the lower a firm’s profits, other things held constant. Second, interest rates affect the level of economic activity, and economic activity affects corporate profits. Interest rates obviously affect stock prices because of their effects on profits. Perhaps even more important, they influence stock prices because of competition in the marketplace between stocks and bonds. If interest rates rise sharply, investors can obtain higher returns in the bond market, which induces them to sell stocks and transfer funds from the stock market to the bond market.

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  Reconstructing Macroeconomics

  Structuralist Proposals and Critiques of the Mainstream

  • Lance Taylor, Lance TAYLOR(Authors)
  • 2009(Publication Date)
  • Harvard University Press

    (Publisher)

  Business people think so, and in the following section we trace through the implications of treating interest payments as a component of cost. 2 Most economists, however, prefer to think of interest as a payment for deferred gratifica-tion and/or the possibility of making higher profits in years to come. This interpretation of the interest rate as a relative price mediating transac-tions between the present and future is built into “real” theories such as those constructed early in the past century by Irving Fisher and Frank Ramsey, among many others. As already noted, Fisher influenced Keynes, while Ramsey’s optimal saving model (along with its “overlapping generations” analog) domi-nates contemporary mainstream thought. Applied in practice, real theo-ries tend to treat the interest rate as the variable which adjusts to clear the market for loanable funds, as in the teachings of J. S. Mill. Loanable funds interest rate models contrast with the “liquidity preference” the-ory developed by the Keynes of The General Theory (to be reviewed in the following chapter). Keynes’s “monetary” analysis dominated the mainstream for a few decades. But it has been eclipsed by the real and loanable funds models presently in vogue. 3. Interest Rate Cost-Push Regardless of how the interest rate is determined, a model developed by Anyadike-Danes, Coutts, and Godley (1988) provides a framework for treating it as a cost that enterprises have to pay to hold inventories—a useful point with which to begin our discussion. To see the details, we can write out a modified version of the cost and sales decompositions ap-pearing in column (1) and row (A) of Table 1.2’s SAM: 3 wbX + π PX + iL = P ( C + I + G ) + P ‰ + ¯ Z . (1) The notation is familiar, except that Z stands for the stock of inventories held by firms and the value of investment PI does not include changes in inventories, which are represented by the term P ‰ .

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