23) how are interest rates determined?

Question 1

what is an interest rate?

Answer 1

In short, the interest rate is a price- the price of borrowed money. Because it’s a price, its level will be determined by demand and supply, in this case the demand and supply of money.

Question 2

where does the demand for money come from?

Answer 2

The demand for money in an economy comes from all economic agents. Households demand money to fund consumer expenditure, firms demand money to fund investment, government to fund government expenditure etc.

Question 3

how to show interest rates and money supply in a diagram:

Answer 3

As with all other “demands” you’ve met (demand for goods & services, aggregate demand, demand for labour), the demand curve for money is downward sloping, left to right. The vertical (P) axis here is Interest Rate whilst the horizontal axis represents the quantity of money. The supply of money is determined independently of the interest rate and is controlled by the central bank. Therefore, we assume that the supply of money line is vertical at a particular quantity of money set by the central bank. Money is traded (demanded/supplied), on money markets. As with all other markets we’ve looked at, the equilibrium price (interest rate) will be where the demand for money (Dm)= the supply of money (Ms).

Question 4

what does it mean for the consumer if there are high interest rates?

Answer 4

At high rates of interest there is little incentive to keep your money in liquid form (e.g. cash or current accounts). This is because other assets are more attractive. For example, long-term savings accounts will pay much higher rates of interest.

Question 5

what does it mean for the consumer if there are low interest rates?

Answer 5

If interest rates are low these alternatives are unattractive, so consumers want money to spend, businesses want money to invest etc

Question 6

diagram 1: how interest rates are determined

Answer 6

Diagram 1: Interest rates are determined by Dm and Ms. Ms=Dm at i1/Q1. A rate of interest above il means the supply of money exceeds the demand so interest rates fall. Likewise, if the interest rate is below i1, then demand for money is higher than the supply of money so the interest rate will rise. It will remain at il unless there is a change in Dm or Ms

Question 7

diagram 2, what happens with interest rates if the central bank changes money supply

Answer 7

Diagram 2: this shows the impact of changes in the Ms on interest rates.

If the central bank increases the Ms (Ms1 to Ms2), interest rates will fall. If the central bank reduces the money supply, (Ms1 to Ms3) interest rates will increase.

The central bank control the Ms in 2 ways first, they can create money themselves, e.g. using QE. Secondly, they can influence the money created by commercial banks through changing the reserve requirement. For example, if a central bank increased the reserve requirement from 5% to 10% banks would be unable to make as many new loans

Question 8

diagram - liquidity trap

Answer 8

Diagram 3: This shows a liquidity trap. Normally, monetary policy works because a change in the money supply changes interest rates, which then goes on to change most other things in the economy. However, in certain situations, e.g. during financial crises, an economy may enter a liquidity trap, when an increase in the money supply does not further lower the interest rate. In a liquidity trap, Dm is perfectly elastic. Increasing the Ms doesn’t reduce interest rates and the central banks intended outcome, boosting demand does not happen. Business and firms instead hoard cash