 |  Money and Capital Markets: Financial Institutions and Instruments in a Global Marketplace, 8/e Peter Rose,
Texas A & M University
The Determinants of Interest Rates: Competing Ideas
Chapter SummaryThis important chapter focuses on the leading ideas today of what determines the level of
and changes in market interest rates and asset prices. Its specific target is the pure or risk-free
rate of interest (such as that interest rate attached to a government bond). Each theory
of interest presented in this chapter attempts to account for the changes we see everyday in
this pure or risk-free market interest rate.
- The chapter explores the critical roles played by interest rates in the functioning of the
money and capital markets and the economy. These fundamental interest-rate roles include
(a) generating an adequate volume of savings in order to fund investment and
growth in the economy; (b) directing the flow of credit in the economy toward those investment
projects carrying the highest expected rates of return; (c) bringing the supply
of money (cash balances) into alignment with the demand for money so the money market
will achieve a stable equilibrium; and (d) serving as a tool of government economic
policy so that the nation can better achieve its broad economic goals of full employment,
avoidance of serious inflation, sustainable economic growth, and a stable equilibrium in
the nation’s balance of payments with the rest of the world.
- The so-called classical theory of interest rates emphasizes the critical roles of savings
and investment demand in determining market interest rates. The supply of savings is
assumed to be positively related to the market interest rate, while the demand for investment
is negatively related to the level of interest rates. The equilibrium interest rate
in this long-run interest rate model is established at the point where the total supply of
savings and the quantity of investment demand are in balance with each other.
- The liquidity preference theory of interest, on the other hand, looks at the demand and
supply for money (cash balances), fixing the equilibrium interest rate in the money market
at the point where the quantity of money in supply matches the total demand for
money. Demand for money consists of money demands for transactions, precautionary
savings, and speculation about the future course of interest rates and security prices. The
supply of money is heavily influenced by actions of the government, principally the central
bank.
- The popular loanable funds theory of interest brings together elements of both the classical
and liquidity preference theories, focusing upon the total demand for credit (loanable
funds) and the total supply of credit (loanable funds). The aggregate demand for
loanable funds includes credit demands from all sectors of the economy—businesses,
consumers, and governments. The aggregate supply of loanable funds includes domestic
and foreign savings, the creation of money by the banking system, and the hoarding
or dishoarding of cash balances by the public. The equilibrium loanable funds interest
rate tends to settle at the point where total demand for credit matches total credit supply.
- The rational expectations theory of interest focuses upon the total expected supply of
credit relative to the expected demand for credit. This view of interest rates and asset
prices assumes that the money and capital markets are highly efficient in the use of information
in determining the public’s expectations regarding future changes in interest
rates and asset prices. Equilibrium interest rates impound all relevant information very
quickly and change only when relevant new information appears. Forecasting market interest
rates is presumed to be virtually impossible on a consistent basis because interest-rate
forecasters must know what new information is likely to arrive before that
information appears and must assess how that new information will influence interest
rates and security prices when it does arrive.
- Collectively, the different views of interest-rate determination discussed in this chapter
help guide us toward those fundamental forces that shape the level of and changes in
market rates of interest. These include such critical forces as domestic and foreign savings,
the demand for investment, the money supply, the demand for cash balances, and
government economic policy (including the workings of central banks around the world).
This chapter sets the stage for future chapters in Part Two of the text where we attempt to
discover what factors cause one interest rate to differ from another (including inflation,
the term or length of a loan, credit or default risk, and many other causal elements).
|
|
2003 McGraw-Hill Higher Education