The Determination of Interest Rates

Abstract

Monetary economics is a subject wherein academic theories and practitioner market experience often seem widely divorced; the determination of the stock of money (Chapter 6) and the operation of foreign exchange markets (Chapter 18) are but two examples. Analysis of the determination of the level of money market interest rates is, alas, another. Accordingly, in this chapter, we try to weave together both practical market experience and more abstract theoretical considerations.

We start in Section 1 with a factual restatement of Central Bank operations. On a day-to-day basis, the determination of the level of market interest rates is a relatively simple affair; the level is set by Central Bank intervention in money markets to balance the market’s desire for cash (high-powered money). The authorities could, in principle, choose to control the quantity of high-powered money instead, but, because of the short-run inelasticity of the market’s demand for cash, they have not generally chosen to do so. Even in those examples (e.g., Switzerland and the American Federal Reserve Board between 1979 and 1982) when there have been some forms of operation tending in this latter direction, these operations have incorporated safety valves to prevent excess instability in interest rates. An account of how these systems worked in practice is given in the Appendix at the end of this chapter.

Nevertheless, any attempt to hold market interest rates constant over any sustained period of time would soon cause more general economic instability; over such long periods of time, the Central Bank sees its ability to influence interest rates constrained by a set of more important political, expectational and real factors to which it has to react continuously. In this context, the adoption of pragmatic monetary targets has allowed such reactions to become more flexible. The inter-relationship between the level of money market rates, set in the short term by the authorities, and rates on longer maturities is discussed in Chapter 11.

Whereas the authorities actually set interest rates in the short run so that the money stock becomes an endogenous variable, most academic analysis of the determination of the rate of interest assumes that the authorities fix the level of the money stock. In Section 2, the theoretical determination of interest rates and the market demand and supply equilibrium of money are discussed. We start with the Neo-classical Theory in which all markets clear perfectly and instantaneously and claim that, in these conditions, monetary disequilibrium is reflected in and adjusted away by general changes in prices; the real interest rate is a function of real variables (e.g., productivity and thrift) and nominal interest rates incorporate an expectation of future inflation (the Fisher effect) plus the real interest rate.

If markets are imperfect, however, with labour and goods markets adjusting slower than financial asset markets, then there will be an initial ‘liquidity preference’ effect on both nominal and real interest rates. Keynes exaggerated the importance of the ‘liquidity preference’ effect, relative to the longer-term ‘loanable funds’ theory of interest, in order to differentiate his approach from the Classical. This led to an invalid concentration upon a small set of financial interest rates as providing the sole means of short-term equilibration of the demand and supply of money and, similarly, the sole transmission channel for monetary policy.

Nevertheless, the process of determination of interest rates does depend on the degree of market imperfection in the time horizon under consideration. As already noted, in the short run, the market rate of interest is determined by the balance between demand and supply of high-powered money. This determines both the market interest rates payable on bank deposits and charged for bank loans. The demand for money is not the same as the demand for bank credit, as will become clear in Section 3 which discusses the banks’ balance sheet. I argue that the general acceptability of money means that some sub-sets of bank deposits are used as buffer stocks, adjusting passively in the short run to fluctuations in the demand for bank credit; fluctuations in bank credit demand, therefore, rule the monetary roost.

This turns out to cause problems for monetary controllers, since such credit demand has proved unpredictable and unresponsive to interest-rate fluctuations. Rather than vary interest rates drastically to influence bank credit demand, the monetary authorities in the UK have sometimes sought to compress bank lending to the public sector. The resulting practical problems of ‘overfunding’ and the ‘bill mountain’ in 1980–5 are recorded.