# The Determinants Of The Rate Of Interest Economics Essay

2733 words (11 pages) Essay in Economics

5/12/16

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Interest rates as defines by various scholars could be referred to as the price on borrowed capital. It could also be perceived as the return on financial assets or on investible funds. Further more, the rate of interest is a payment from borrowers to lenders which compensates the latter for parting with funds for a period of time and at some risk. Put into real terms, it is often said that lenders are being encouraged to forego consumption now in conditions of comparative uncertainty, in return for consumption later, in an uncertain future. In rewarding savers with parting with funds, a rate of interest is strictly speaking rewarding savers for giving up the ability to consume if they should change their mind about savings. After all, there is a perfectly rationale case to be made for people to save (forego actual consumption) at zero, or even negative, real interest rates since they will wish to provide for old age or other future periods of zero income.

Types of Interest rates:

There are basically two types of interest rates, namely; nominal interest rates and real interest rates.

Nominal interest rate is the actual interest payment by the borrower of funds or on financial assets/instrument for the use of borrowed or loaned funds. It is the rate that is actually paid in money form. It is usually denoted as i in mathematical equation.

Real interest rate on the other hand is the effective rate paid on borrowed or loaned funds over the tenure or maturity of the loan. It is the interest rate paid or received after taking account of inflation. Real interest rate is denoted as r and inflation rate written as Ï€.

Thus i = r + Ï€.

Given the definition and explanation of interest rate as a measure of reward for savings, reward for investments and what consumers get for the consumption postponed. For instance, investment in money market securities like treasury bills, commercial paper/banker acceptances, bonds and bank deposits give investors returns expressed as yield, discounts, coupon and interest payments respectively on their investments. Capital market investments like shares, provide dividend in return to investors. All as a measure of interest rate on investment terms.

Macro Economic Objectives;

All over the world, every government and regulatory authorities pursue economic policy objectives as listed below of which interest rate is used as one of the tools to achieve any of the goals. These include:

Full employment of resources

Income distribution

Balance of payment equilibrium

Price stability

Efficient allocation of resources… and for outside economy,

Full freedom of cross-border capital movement

A fixed exchange rate

Economic theory of interest rates

Howells and Bain 2005:183 posited that discussion on interest rates cannot be exhaustively illustrated without making reference to the relevant economic theories on same. The classical theory, Neo-Classical theory which propounded the Loanable fund Theory and as well as the Keynesian and Monetary positions on interest rates which stipulated Liquidity Preference theory on interest rate.

Classical theory – principally propounded by Fisherian. He posited that interest rate is an equilibrating factor between the demand for and supply of money. Thus, interest rate is the price at which the two are equated. Classical concluded that interest rate is a long run phenomenon and at the long run, the rates which prevails is determined exclusively by real forces of investment and savings. In this instance, classical assume that savings is the only sources of investible funds and both savings and investments are interest eligible.

In addition, savings means an increasing function of interest rate while investment is a decreasing function of interest rates. The theory based its conclusion on some underlying assumptions; like prices flexibility exists. The economy will always be at full employment. And interest rate has no relationship with monetary factors because money supply is exogenously determined.

This it denoted as follows:

S = S (r)

I = I (r)

Neo-Classical theory – Also referred to as Loanable fund Theory: This was developed by Knut Wicksell and further developed by Gurnar Myrdel, Eric Lindelle, Bent Hansen and Bert Hollids. They are all economist that belong to the Scottish school of economic thought.

Neo-classical theory of interest rate is thus a refining and an attempt to modernise as well as remove the inherent shortcomings of the classical theory of interest rates.

Knut Wicksell introduced credit money into the classical theory as well as hoarding i.e beside savings and investment, the loanable fund theory recognises the role of banks in credit creation as well as the role of the public in hoarding, which form part of money supply balancing.

The inclusion of credit money into the equation results in increase in the amount of funds available in the banks. To attract investors, the interest rates must fall Wicksell contended that the credit money has no relationship with interest rates. He identified two types of interest rates, namely;

The natural interest rates (r n)

The market interest rates (r m)

The market interest rates is below the natural interest rate.

The Wicksellian theory was refined by his colleagues such as Gurner Myrdel, Eric Lindelle, Bent Hansen & Bert Hollids who argued that in creating credit, bank’s take cognisance of the cost of fund i.e interest rate. In addition, there is hoarding of money by people which sometimes are used for speculative motive. This therefore, affects the investment schedule.

They thus, proposed that interest rate is determined by the following four factors:

The investment level

The savings level

The money creation

The hoarding ability.

Like Wicksell, they arrived at two levels of interest rates; the natural interest rate and the market interest rate.

Criticisms:

-Keynes criticised the theory on the ground that income is a better determinant of interest rates and this is ignored by both the classical and Neo-classical.

-Interest rate is better determined in the monetary sector than the real sector as argued by the classical schools.

Thus, the demand for and supply of money are better determinant of rate of interest.

Keynesian Theory of Interest Rate – Liquidity Preference Thoery

According to Keynes, interest is a monetary phenomenon, it is therefore, determined by the demand for and supply of money. Money supply is exogenously determined by monetary sector.

Demand for money is interest elastic denoted as (mt+mp), given the speculative demand function, such that the higher the interest rate the higher the cost of holding money and people will invest in bonds. Equilibrium interest rate is formed at the point of interaction between the demand for and supply of money.

Keynes argued that principal determinant is income rather than interest rate. Although, interest rate may influence it. He added that investment is determined by interest rate which is linked to marginal efficiency of capital (MEC). Keynes therefore, posited in the general theory (written in 1936 on income, employment and price), that the function of monetary sector is to determine the rate of interest which result in balancing of demand for money with the available supply.

Therefore, making interest rate purely monetary phenomenon. Note that Keynes analysis is always on shortrun (i.e use of i for interest instead of r). Keynes opined that continuous increase in money supply could drive the interest rate down to a level where people will hold their money indefinitely leading to a situation referred to as liquidity trap and at this level monetary policy becomes ineffective.

This further put the money demand equation to be Mt + Mp + Msp.

Where:

Mt – Money demand for transaction (t) motive

Mp – Money demand for precautionary (p) motive

Msp – Money demand for speculative (sp) motive

Criticism:

The monetarist argued that there is no rationale to accept the view that interest rate is determined in the monetary sector.

They contended that demand for money remain interest inelastic (i.e interest rate may not be achieved of the demand and supply will remain inelastic and this equilibrium point may not be achieved)

General Equilibrium Theory of Interest Rate – Hicksian Theory (J.R.Hicks)

Contrary to Keynes position that interest rate is purely a monetary phenomenon and the classical belief that it is a real sector affair. Hicks (1937) argued that a truly general equilibrium interest rate determination must exist within the framework of a general equilibrium analysis. In such analysis, the determination of interest rate that is common to the whole economy must be found to include savings, investment demand, liquidity preference and the quantity of money.

Hicks agreed with the classical that interest rate can be determined in real sector by demand for and supply of loanable funds. The demand for loanable fund is given by investment while the supply is given by savings and dishoarding. He further explained that it is important to look at the basic relationship between interest rate and savings via changes in income. In this case, if income increases, the level of savings will also rise and to attract investor, interest rate must fall.

S = f( Y, r)

I = g(r)

S = I

Combining difference levels of equilibrium., we arrive at IS curve (Interest Savings curve) which is defined as the locus of combination of real income and interest rate that are required to keep the economy in equilibrium in the goods and commodities markets with savings equalling investments.

S = I

Using the Keynesian’s analysis of demand and supply of money, Hicks posited that when income increases, the demand of money will also increase and its schedule will shift upward establishing a new equilibrium position. Continuous increase in income will also lead to continuous increase in the demand for money and resulting in new equilibrium. Meanwhile, the money supply is assumed to remain constant.

f = Md2Ys

e= Md1Y1

d= Md0Y0

Joining different points of equilibrium resulting in LMs curve, which is defined as the locus of combination of real income and interest rate that are required to keep the economy at equilibrium in the money market, provided prices remain constant.

LM Equation: MS=Md

Md = L1(Y)+ L2(r)=f(Y,r)

Where L1(Y) = Mt+Mp

L2(r) = Msp

Thus, Ms = Md.

Hicks then concluded that when price remained constant overtime, we can argue that real income and real interest rate are involved in the monetary sector. Combining the IS and the LM curves, within a general equilibrium framework, will naturally give a general equilibrium interest rate. He further concluded that interest rate at the long run is stable.

The yield curve:

This is the term used to explain the relationship between an instrument’s yield/ rate of, returns and its time to maturity. This is also known as term structure of interest rates.

Policy Trilema

Policy trilema arises from what is referred to as ‘impossible trinity’ where a policy maker cannot simultaneously keep the exchange rates stable, use interest rate policy to target inflation and at the same time maintain an open capital account. A case in point was Indian experience. The incompatibility of these three micro economics objectives creates trilema of which most countries do not usually give up on any of the objectives.

In other words, trilemma arises where cases of inconsistencies frequently noticed in the implementation/utilisation of various monetary policy instruments to achieve some of the macro economic objectives.

Full freedom of cross-border capital movements,

A fixed exchange rate; and

An independent monetary policy oriented towards domestic objectives.

Liquidity Trap

As earlier noted, Keynes opined that liquidity trap situation occurred where there is a continuous increase in money supply which could drive the interest rate down to a level where people will hold their money indefinitely. At this level, monetary policy becomes ineffective. An empirical analysis of a liquidity trap situation was that of the Republic of Japan experience as projected by Paul Krugman (May 1998). It was stressed that Japan experienced serious economic depression, where there was shortfall in aggregate demand and economic authority felt printing of more money could cure the situation to lubricate activities, instead, Japan had a near-zero short term interest rates and the Bank of Japan expanded its balance sheet at the rate of 50% without improvement.

Factors Determining the Rates of Interest

In Developing countries/economy

The opportunity cost of money: This goes a long way to determine the rates of interest as lenders or creditors consider and factor in the cost of alternative use for their funds in order to maximise return. This is mostly practicable in developing economy.

Administrative premium: Borrower tends to add up other costs of packaging loanable funds to borrowers which in turn add up to effective rates of interest on the funds.

Amount of the Loan: In a perfect market condition, the larger the amount of loanable funds the lower the rate of interest and vice versa.

Borrowers financial standing, credit worthiness and the risk profile/rating of the borrower:

Inflationary rates: An economy with high inflation rate which results in increase in general price levels relative to other countries tends to have higher interest rate regime in both monetary and fiscal activities.

Level of money and capital market development:

Liquidity position of the financial institutions like banks.

Government Monetary Policy objectives: The economic policy objectives and direction of the regulator will largely affect the level of interest rates.

Value of Collateral securities:

In Developed countries/economy

The desires, preferences and actions of other actors in the market.

The quality and viability of the financial instruments.

Premium for risk: The risk profiles of a project and business venture has a direct relationship with the cost of financing the project and hence the rate of interest as well as return on such investment.

The level of economic development, the capacity of the economy to accommodate the financial instruments.

Importance of Interest rates

Interest rate is important to firms and individuals mostly to facilitate an avenue to monitor and manage cost of funds and operational efficiencies. It facilitates planning and as well as assess performances individually or by corporate bodies. The speculators, hedgers, arbitrageurs and other market actors use interest rate for business and investment decisions. For the policy makers, apart from using interest rate as a monetary policy control tool in regulating, managing and providing policy direction for the economy, it is a principally tool use for liquidity management and money supply in an economy. This is usually implemented through financial institutions like banking system via discount rate and reserve requirements by regulatory authorities such as Central Banks and Federal Reserve banks in various countries.

## Conclusion

As clearly illustrated and clarified above, it has been established that interest rate is an important tool for both firms, individuals, corporate bodies and the government given its usefulness to their respective activities and roles in economic developments. A thorough understanding of the nature, types and behavioural aspect of interest rates will go a long way to propel all market dealers and actors into effective and viable investment decisions and for a policy maker the relevant policy measures required to achieve economic objective. Theory of interest rates will always be a case study and reference point as research topics for the scholars in view of its critical roles and uncontroversial roles it plays in economic activities of human life.

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