Explain in detail how interest rates are determined in the money market. Examine the likely consequences for the macroeconomy of a reduction in the rate of interest and highlight the factors that might limit the effects.
This essay is going to demonstrate how the rate of interest is determined in the money market. It will examine the impact that a reduction in the interest rate has on the economy. The framework used will be the interest rate mechanism, where an increase in the money supply will change interest rates and stimulate interest-sensitive expenditures. It will then highlight the factors that can limit and offset the effects of a reduction in the interest rate.
The interest rate is defined by Sloman et al. (2012) as the price paid for borrowing money. Two factors that determine the interest rate is the supply of money and the demand for money. The supply of and demand for money in the economy interact together to reach a level of equilibrium. According to Sloman et al. (2012) the money market is a market for short-term debt instruments in which financial institutions are active participants. Figure 1 and 2 illustrates the money market and the demand for money. The demand for money refers to an individual’s desire to hold their wealth in the form of money instead of using it to purchase goods or financial assets. The money demand curve is downward sloping as an increase in the interest rate leads to a decrease in the quantity of money demanded. Money supply is the entire stock of currency and other liquid instruments in the economy. The money supply is set by the central bank (Bank of England) and is exogenous (does not depend on the demand for money). The money supply is fixed and is not influenced by the rate of interest. In figure 1, the x-axis measures the money supply, the y-axis represent the rate of interest and the L curve represents the liquidity preference curve (demand for money). The money supply is represented by the vertical line Ms. The intersection of the money supply and money demand curves reveals the equilibrium rate of interest and is fixed at that point where they equate. According to Keynes the intersection of the curves is purely a monetary phenomenon.
John Maynard Keynes (1936) in his book the General Theory of Employment, Interest and Money described the demand for money through liquidity preference framework. According to this theory, the primary reasons for holding money are for transactional, precautionary and speculative demands. The sum of all three demands make up the total demand for money. According to the theory, if interest rates are high individuals demand for money (liquidity preference) is low and when interest rates are low, the demand for holding money increases. In figure 2, the curve L1 is the transaction plus precautionary demand for holding money. L stands for the liquidity preference and by definition; the liquidity preference is the demand for holding assets in the form of money. L is the total demand for money balances and is derived by the horizontal addition of curves L1 (the transactions plus precautionary demand for money) and L2 (the speculative demand for money). The shift from L1 to L2 illustrates a shift in the liquidity preference (an increase in the demand for holding assets in the form of money).
The interest rate mechanism is graphed in a three-stage process. Stage 1 illustrates the money market, where an increase in the money supply from M to M’ (with everything else being equal) leads to a fall in the rate of interest from r1 to r2. At stage 2, the fall in the interest rate leads to an increase in the level of investment from I1 to I2. The increase in the level of investment translates in the third diagram shown in stage 3. Lower interest rates increases investment as it becomes relatively cheaper for firms to invest and businesses to take out loans to finance greater spending and investment. Stage 3 shows how a rise in investment leads to a multiplied rise in the national income from Y1 to Y2. Stage 3 shows the Keynesian withdrawals and injections function where an increase in investment has increased the level of injections J1 to J2. This excess in injections over withdrawals will lead to a rise in the national income from Y1 to Y2. Interestingly, an increase in the level of income means that consumers will have more disposable income for consumption purposes (Sloman et al. 2012).
Consumption is the largest component of aggregate demand and has an effect on other components of aggregate demand such as net exports and investment Griffiths and Wall (2007). Lower interest rates increases the level of consumption by making the opportunity cost of consumption is lower. This encourages greater expenditure as borrowing through credit cards becomes cheaper. Lower interest rates makes saving less attractive by reducing an individual’s incentive to save. This lower incentive to save encourages consumers to spend rather than to hold onto money. It also reduces the income from savings and the interest rate that is due on loans taken out. However, borrowing now becomes more attractive and this stimulates an increase in spending. Lower Interest rates can boost the prices of assets such as shares and houses. Higher house prices means that current home owners must extend their mortgages which further enables them to finance higher consumption. Interestingly, the higher asset prices increases the wealth of households (through the wealth effect) which increases their incentive to spend as confidence will be higher. Higher asset prices means that businesses are also able to finance their investment (purchase of capital) at a lower cost. Lower interest rates also reduces the cost of interest payments on mortgages by reducing the monthly cost of mortgage payments. This increases the disposable income of householders which increases their level of spending. Moreover, lower interest rate can reduce the value of the Pound Sterling. If UK interest rates fall relative to overseas, saving money in UK becomes less attractive as higher returns can be earned in another country. This reduces the demand for the pound sterling and causes the reduction in the value. In figure 6 at stage 2, the fall in the currency is due to a decrease in the demand for the Pound Sterling in the foreign exchange market. The rise in the supply of the domestic currency from S1 to S2 leads to a fall in the demand for the currency from D1 to D2 and this causes a depreciation in the exchange rate from er1 to er2. This fall leads to a rise in the demand for exports as UK exports become relatively cheaper and more attractive overseas. There will also be a fall in demand for imports (as they become more expensive) and thus causing an increase in the national income (which further increases spending).
What if other factors can offset the full extent of a reduction in interest rates? There exist time lags in the economy that can limit the impact of rate cuts on the level on interest-sensitive expenditures. In figure 4, the increase in the money supply lead to a multiplied effect and resulted in a rise in the national income. However, the mechanism failed to highlight how a rise in income will also lead to a rise in the transactional demand of money (L1). In this circumstance, at stage 1, L1 would shift to the right and thus lead to a smaller fall in the interest rate than illustrated. Thus, the level of investment at stage 2 and the national income at stage 3 will not rise as much as shown as well. The overall effect of the money supply on national income will depend on the size of each stage. Their relative sizes depend on the shapes of the liquidity preference and investment curves (as in figure 6 and 7). A bigger change in the interest rate will be caused if the liquidity preference is less elastic. The more interest-elastic the investment curve is, the bigger the change in investment. If the marginal propensity to withdraw is lower and therefore the curve is flatter, this will cause a bigger multiplied change in the national income than illustrated (Sloman et al. 2012).
Keynesian economists stress how volatile stages 1 and 2 are in the interest rate mechanism. What if increasing the money supply leads to no interest rate reductions? What if investment is inelastic and cannot be influenced by changes in rates. Figure 6 illustrates an elastic liquidity preference curve. The less elastic the liquidity preference is, the bigger the change that will be caused in the interest rate. Due to its gently sloping curve, a rise in the money supply from M to M’ will lead to an only small fall in the interest rate. This will them limit the impact that the interest rate has on consumption, saving decisions and any other interest-sensitive expenditures. According to Keynesians, the demand for money (L) can be very elastic in response to changes in the interest rates and the liquidity preference curve can become relatively flat. The full effect of a rate cut can be limited greatly by the nature of the demand curve. At r2, if individuals perceive and expect no further rate cuts, any increase in the money (from M’ to M’’) will have no impact on r. The liquidity trap is where Keynes believed this additional money will be lost in. within this theory, interest rates have a floor where an increase in the money supply has no further impact. The financial crisis 2008-09 was a predicament where policy makers feared that increases in the money supply will lead to idle balances lost in the liquidity trap. The central bank used an unconventional monetary policy known as quantitative easing, where they deliberately increased the base rate via the purchase of bonds and other securities in exchange for money. This process of credit creation was used to increase bond prices and thus reduce the interest rate and stimulate growth. Arguably, increases in the money supply will have some impact on the rate of interest as we have seen in the financial crisis where deliberate increases in the money supply lead to further increases in the interest rate and thus spending as well (Sloman et al. 2012). Figure 8 illustrates the effect on interest rates of an unstable liquidity preference curve. This figure further explains how the liquidity preference curve fluctuates due to factors such as expectations in the inflation rate and direction of the interest rate (to name a few). Therefore, due to its instability it is difficult to predict the effect on interest rates of a change in the money supply.
Another factor that can influence the investment schedule are changes in investor confidence. An increase in investor confidence can shift the investment curve to the right and at any given interest rates, firms will want to invest more. A decrease in their confidence would shift the curve to the left. If investors believe that the economy is going to get out of recession, their confidence and level of investment will increase. If firms believe that inflation will rise and that the central bank will soon increase the interest rate, confidence and investment in the economy will be low (Sloman et al 2012). In Figure 7, a bigger change in investment will be caused if the investment curve is more interest-elastic. In the liquidity preference framework, investment demand is unresponsive to interest rate changes and that a large change in the interest rate is detrimental to affect investment. Evidence to confirm this was illustrated through the impact of investor confidence. This consensus on the behaviour of investment can be argued in that the focus should be more on how volatile and erratic investment is in response to confidence than its responsiveness to the interest rate. For example, in figure 9, the impact of a fall in interest rates is limited by business confidence. Initially, the reduction in the interest rate has increased investment. However, if the fall in interest rates is accompanied by an increase in business confidence by investors, the investment curve will shift from l1 to l2. On the other hand, if the fall in the interest rate is accompanied by a decrease in confidence then the investment curve will decrease and fall shift from l1 to l3. This impact is contrary to what was illustrated when the investment curve was believed to be inelastic. Therefore, expansionary monetary policy is likely to be more effective if firms have confidence in its effectiveness (Sloman et al. 2012).
In the liquidity preference framework, the assumption is that an increase in the money supply leads to lower interest rates if everything else remains equal. However, in reality an increase in the money supply might impact other factors in the economy that could increase the interest rate instead of decreasing it. Two factors to highlight are the income effect and the price-level effect. The income effect describes how an increase in the money supply has an expansionary influence on the economy and this in effect raises the national income and wealth. The liquidity preference theory predicts that an increase in the national income and wealth will increase the interest rate and offset the original impact of an increase in the money supply. Another effect that can limit the impact of a reduction in interest rates is the price-level effect. In this effect, an increase in the money supply increases the overall price level which also increases the interest rate.
In conclusion, economics is a social science where theories are constantly examined and redrafted. In the interest rate mechanism theory, an increase in the money supply will lower interest rates and stimulate interest-sensitive expenditures. This stimulation will have a multiplied effect on the level consumption, business investment, mortgage payments and asset prices. However, the impact of a reduction in the interest rate on the economy is quite a complex subject to address. Many determinants must be factored in for the full impact to be noticeable. Even if the overall effect of a reduction in the interest rate is quite strong, it is highly unpredictable to measure and estimate the magnitude of it. Investment is influenced by confidence and on elasticity to the interest rate. This changes the original impact of a rate cut. The nature liquidity preference curve can be highly unstable and not be impacted by any changes in the interest rate. There also other factors like the price-level, expectations and income that can impact and offset the intended purpose of an increase in the money supply.
All the factors highlighted in this essay can limit and offset the impact of a reduction in interest rates on interest-sensitive expenditures and the growth of the economy.
Keynes, J.M. (1936), The General Theory of Employment, Interest and Money, CreateSpace Independent Publishing Platform
Griffiths, A. and Wall, S. (2007) Applied economics, 11th ed. Harlow: Addison Wesley Longman.
Sloman, J., Wride, A. and Garratt, D. (2012) Economics, 8th ed. Harlow: Pearson Education Limited.