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The

Determination of

Interest Ratesand the MPC

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Overview

Candidates should understand how the demand for, andsupply of, funds in different markets affect interest rates.Candidates should have an understanding of the factors

considered by the MPC when setting interest rates.

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The Three Key Functions of Money

Medium of

Exchange

Unit of Account

Store of Value

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The Money Supply 1

Money supply: the total amount of money circulating in the economy.

Cash SightDeposits

TimeDeposits

TreasuryBills

PhysicalAssets

Liquidity

Narrow money: notes and coins. (M0 is cash and M4 isphysical assets). This includes the spectrum of liquidity in

the economy.

Broad money: money used for saving as well as spending.

All types of assets (M4).

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The Money Supply 2

Interest Rate (%)

Money Balances

MSMS is perfectly

inelastic as there is a

fixed stock of money inthe economy.

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The Demand for Money 1

Demand for money: the amount of money that people like to hold as

cash rather than in other forms.

Three reasons for holding money:

Transactionary demand: to buy goods and services. Based aroundaggregate demand.

Precautionary demand: just in case.

Speculative demand: to take advantage of investment opportunities.

Demand based on the interest rate charged, this will depend onwhether you hold cash or financial assets.

ISAs or savings accounts, the higher the interest rate, the higher the

opportunity cost of holding.

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The Demand for Money 2

Interest Rate (%)

Money Balances

LP

The lower the interest rate, the more cash you will want to hold instead

of assets.

Interest rate is what you forego.

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Interest Rate Determination 1

Interest rate: the cost of holding wealth as money.

The interest rate is just a price: the price of money.

An interest rate is determined in the usual microeconomic manner: by

the interaction of its supply and demand.

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Interest Rate Determination 2

The Central Bank determines theoverall money supply.

Through this it can influence thecentral interest rate, which thenfilters through all interest rates.

The LP curve is primarily determined

by the level of income. Bank of England raised the money

supply and reduced interest rateswhich meant there was no need tohold financial products which areinterest bearing.

Interest Rate (%)

Money Balances

LP

MS

IR*

Glorified supply and

demand diagram for

money.

Liquidity

preference.

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Interest Rate Determination 3

An increase in the moneysupply:

Reduces the interest rate.

Increases borrowing,

spending and investing. Increases aggregate

demand.

Interest Rate (%)

Money Balances

LP

MS1

IR1

MS2

IR2

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Interest Rate Determination 4

An increase in the level of income: Increases the demand for money. Increases the interest rate. Reduces borrowing, spending and

investing. Reduces aggregate demand. Liquidity preference is the demand for

money which is based around interest. Low interest equals less demand. Banks have harder regulations now-

govt wanted to lend more but you haveto have 25% deposit instead of 5%.

Interest Rate (%)

Money Balances

LP1

MS

IR1LP2

IR2

When there is

more demand

for money,

interest rates

are raised to

disincentivising

people to save

money.

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Interest Rate Determination 5

There are countless different interest rates in the economy.

Each is determined by the demand for and supply of theparticular asset for which the interest rate applies.

Reasons why interest rates differ:

Time- The longer you hold money, the better the rate of return. Expectations- If you keep taking money out, there is a risk for the

bank to keep money.

Risk.

Administrative costs.

Imperfect knowledge.Bank of Englands interest rate establishes a competitive environment ofinterest. Demand and supply of money is determined by risk, more risk, thehigher the rate of return. But with forward guidance, the Bank of England istrying to counter act lack of confidence.

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The Monetary Policy Committee 1

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The Monetary Policy Committee 2

Interest rates are set by the Banks Monetary PolicyCommittee. The MPC sets an interest rate it judges will

enable the inflation target to be met. The Bank's MonetaryPolicy Committee (MPC) is made up of nine members the

Governor, the two Deputy Governors, the Bank's ChiefEconomist, the Executive Director for Markets and four

external members appointed directly by the Chancellor. Theappointment of external members is designed to ensure that

the MPC benefits from thinking and expertise in addition tothat gained inside the Bank of England.

Bankofengland.co.uk

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The Monetary Policy Committee 3

Factors the MPC consider when setting interest rates:

The inflation target- If there is spare capacity there will be non-

inflationary growth for a period of time which is what were in at the

moment. The higher the inflation target, the lower the interest rate.

The level (and growth rate) of aggregate demand: the output gap.

The level (and growth rate) of production costs.

Expectations.

Performance of other economies- high inflation in EU means high

inflationary pressure in the UK.

House prices- housing bubble means interest rates may have to be

raised to reduce demand.

Exchange rate trends.

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What You Should Know

What is meant by money?

What is meant by the demand for moneyand whataffects this?

What is meant bythe supply of money

and what affectsthis?

How do the demand for and supply of funds in differentmarkets affect interest rates?

What factors are considered by the MPC when settinginterest rates?

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Has Quantative Easing Been

Succesful? It did reduce the deflationary pressure.

However it didnt particularly increase consumer and business confidence

because banks held onto the money from bonds to secure themselves and

pay off the debts which they had defaulted on in the boom years.

Out of the first round of 200 billion QE only 25 billion was bought by

banks.

QE is designed to raise asset prices and thus boost spending to increase

inflationary pressure.

Significant time lag and hard to measure its success.

Gilt prices rose by 20% and yield decreased by 1% which is better than

without QE. Inflaiton rose by between 0.75% and 1.5%.

David Smith- What shouldve been an emergency tool became an everyday

instrument.

Savers have received 70 billion less than they wouldve done without QE.

Only top 10% richest households gained by a 129,000 increase in wealth/

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Liquidity Trap

Consumers and businesses have expectation of what constitutes a normal

rate interest. Their expectations of where interest rates are likely to head in

the future can affect their spending and savings behaviour.

Consider a situation where a central bank has slashed interest rates to

abnormally low levels perhaps because they fear a deep recession or to

reduce the threat of price of deflation. When interest rates are very low, people may downgrade their forecasts for

the returns likely on investment such as property, stocks and bonds. The low

interest rates may tell them that something is badly wrong in the economy.

As a result they may choose to hoard cash or save a rising share of their

income in short-term interest bearing accounts. They key is that they think

that the next move in interest rates is likely to be upwards because interestrates are rarely at abnormally low levels.

The expectation of interest rates moving higher may encourage them to

save even more and postpone consumption even though the central bank is

trying to stimulate spending through a low interest rate policy.

Savings rates are high at the moment, it goes against conventioanal theoryand so monetary policy is not as effective.

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How to overcome the liquidity

trap.1. In a liquidity trap, fiscal policy may become more important as an

instrument of demand management e.g. running a larger budget

deficit to boost demand through the circular flow and increase the

money supply.

2. There is also pressure on central banks to supply the financial

markets with extra liquidity to encourage them to lend to each

other again and increase the flow of funds available for borrowers

3. A rise in inflation can also help! Because higher inflation can lead

to real interest rates becoming negative and eventually

stimulating an expansion of household and corporate spending.

This is happening in the USA now.

4. The central bank may want to establish in peoples minds that

they will keep real interest rates low .

5. 2/3rds of business investment was cut during the recession.

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Credit Crunches

A second reason why low interest rates may not work to

stimulate demand is when there has been a collapse in

confidence in the financial sector leading to a credit crunch. In

this situation the major financial institutions such as banks,

building societies and other lenders may decide to cut theamount that they are (i) prepared to lend to each other and

(ii) prepared to lend to personal and corporate borrowers.

A fall in the supply of lending raises inter-bank interest rates

and creates a dis-connect between official policy interest rates

and the cost of borrowing in wholesale and retail creditmarkets. We have seen some evidence of this in the UK in

recent months with the Bank of England cutting interest rates

gradually but at the same time, mortgage interest rates have

risen (and mortgage loans have become harder to get).

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Liquidity Trap- Demand for money is perfectly

elastic.

Rate

of

Intere

st

Demand for

Money