Importance and Determination of Interest Rates

Determination of Interest Rates
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Table Contents Introduction. 3 Very low-interest rate. 3 Too high-interest rate. 4 Effects of Fed on short-term interest rates. 5 Importance of interest rates. 5 Theories for interest rate determination. 6 Marginal Productivity Theory. 6 Demand and supply theory. 7 Abstinence theory. 7 Time preference theory. 8 Loanable funds theory. 8 Liquidity-preference theory. 8 The loanable funds theory. 9 Demand. 9 Supply. 10 Criticisms. 10 Effects of an increase in money supply. 12 Effect of price level on interest rates. 12 Conclusion. 13 Bibliography. 14
Introduction
Money is a critical factor of any economy because it enables people in the transaction of business and exchange voluntarily. However, most people do not understand how money achieves this important role. The amount of money available in financial institutions and the economy at large plays a significant function in determining interest rates. Also, the amount of money in a country influences two very crucial variables; the inflation rate and interest rate CITATION Car03 \l 1033 (Walsh & Pascual-Leone, 2003). The money supply in a country is usually the amount of currency and coins in circulation and the total amount of cash in financial institutions. The two assets described are mostly in liquid form. This means they can be used to purchase commodities. While a county is responsible for its expenditures, the total amount of money to be spent by that country lies within the central bank jurisdiction. The central bank is also mandated with the responsibility of regulating the money in circulation (Keynes, 2016). While the central bank regulates the movement of money in a country, there is also the aspect of money demand, which is the demand by the government and businesses for highly liquid assets like checking of account deposits, and it is mainly affected by people when they want to buy commodities very fast. Thus, money supply, equilibrium rate and gross domestic product (GDP) among other important factors are vital in the determination of interest rate.
Very low-interest rate
When the interest rate is too low, it affects real demand and real supply for money CITATION DND05 \l 1033 (Dwivedi, 2005). When people save most of their money in accounts, and there is insufficient circulation of money in the economy, real demand for money exceeds the real supply for money. Therefore, it means that people need to have money in liquid form so that it can circulate within the economy. Also, when money demand is high, it means businesses will be forced to change their money which is in the form of assets to liquid form or even converts it into cash. The money people have in their wallets constitutes the money supply. However, too many conversions of money make the interest rate to go below the equilibrium which makes the financial sector to experience lower time deposit balances, something which will lower their ability to make loans. In other words, when people withdraw their savings from accounts, it makes the financial sector to have a reduced amount of money for giving out loans. When the demand for loans remains the same, and there are fewer funds, banks and other financial institutions respond by raising interest rates. Higher interest rates will hinder people from assessing loans at high demand, therefore, equalizing demand and supply for loans. Notably, increased interest rates lead to decreased money demand until it reaches a point when it is equal to the amount of money supply CITATION Dav13 \l 1033 (Gowland, 2013). In such a scenario where money demand is higher than money supply, average interest rate rises.
Too high-interest rate
In circumstances of higher interest rate than the equilibrium rate, real supply of money exceeds its demand which means that people and businesses have more money in liquid form to spend than they need. The solution is only achieved by converting the solid money, in the form of assets into deposits which bears money. An actual transaction would involve one transferring money from his or her wallet into their account CITATION GTi16 \l 1033 (Tily, 2016). This would reduce people from holding much money because there is a reduction in currency in the transaction. However, it will increase the amount of money available for the banks to give loans. In the face of steady loan demand, increase in the number of funds which can be given out as loans will act as a motivating factor for banks to lower their rates of interest to motivate more people to get the loans. However, the demand for money increases with the decrease in interest rates until it reaches the point of being equal to the money supply. In such a mechanism, an increase in money supply compared to its demand leads to lower interest rates.
There are three forces which determine interest rates, including the Federal Reserve, which is involved with the fed funds rate CITATION Sid11 \l 1033 (Homer & Sylla, 2011). It affects variable interest rates and the short-term. Secondly, the investor demand concerned with U.S treasury notes and bonds which affects fixed and long-term interest rates. The banking industry is the other force which offers mortgages and loans that vary their interest rates depending on the needs of the business. For instance, financial institutions may raise interest rates for payment of a credit card if it gets lost in the hands of the customer.
Effects of Fed on short-term interest rates
One of the rates banks charge to other financial institutions for a loan of up to one day to meet the requirements of the Fed reserve is called Libor which means London Interbank Offering Rate. Interest rates have significant effects on the economy in the long run. Changing of the Fed Funds rate by the Federal Reserve, it may take a period of up to one year and one to one and half years for the whole rate to impact on the economy CITATION MOs14 \l 1033 (Osborne, 2014). Increase in interest rates makes the banks to reduce their lending while consumers will have low purchase because they will notice that they do not have enough money as they had initially.
Importance of interest rates
Interest rates are vital because they regulate the amount of money circulating in the economy. While too high-interest rates slow down economic growth, they also help to curb the inflation. On the other hand, low-interest rates make the economy to grow faster; however, they may cause inflation. A decrease in the Consumer Price Index with an increase in interest rates leads to a stable economy because it means that the economy is not overheating CITATION Jef11 \l 1033 (Herbener, 2011). However, the decrease in the gross domestic product while interest rate increases lead to a very slow economy, something which may cause a recession. Increase in GDP with a decrease in interest rates boosts the economy which makes the country to develop faster since there is enough money to cater for all the needs of that country from the financial perspective. Interest rate affected the economy of the United States significantly during the 2008 recession which led to an inverted yield curve after the short-term rates of the Treasury Note long-term rates went below the short-term rates going as low as 1.442 percent CITATION Sid11 \l 1033 (Homer & Sylla, 2011)
Moreover, interest rates affect the individual in various ways. For instance, one will be forced to pay a higher loan if the interest rates are high. Interest rates have the highest impact on home mortgages. One is likely to acquire a less expensive home CITATION DND05 \l 1033 (Dwivedi, 2005). However, the home value may decline in the cases of increased interest rates.
On the other hand, one is likely to benefit more if interest rates are too low because they will curb the inflation, which means the prices of commodities will go down and people will have more money. Saving in a fixed interest loan may make one benefit more from such rates CITATION Lar86 \l 1033 (Hörngren, 1986). However, continued high-interest rates may affect businesses negatively since it causes a recession, which in turn leads to slowed businesses.
Theories for interest rate determination
Marginal Productivity Theory
According to this theory, marginal capital productivity determines the interest rate whereby individuals pay interest because of productive capital which equals the capital’s marginal product CITATION Car03 \l 1033 (Walsh & Pascual-Leone, 2003). The role of capital in the modern production system is fundamental since one can produce higher volumes than the ones produced without capital. Accordingly, interest rates increase with an increase in the productivity of capital. Therefore, one can use capital until they reach a point when marginal product of capital is equal to the rate of interest CITATION Fra09 \l 1033 (Fabozzi & Drake, 2009). However, unlike other factors, it is difficult to determine the marginal product of capital since all the factors contribute to jointly producing the product. Additionally, the theory majors on one side because it only focuses on the demand side of capital for the interest determination, hence limiting it only to one side of the market.
Demand and supply theory
This theory postulates that supply, as well as the demand for capital jointly determines interest rates. The demand for capital depends on its marginal product and the capital supply by saving or waiting. Equilibrium level regarding the rate of interest is achieved when demand and supply for capital are equal CITATION Dav13 \l 1033 (Gowland, 2013). However, the theory faces criticism on the basis that it assumes that all people are employed, something which not true since a majority of people lack jobs. It, therefore, becomes a challenge to apply this theory in some areas. Moreover, the theory does not account for the effects the changes it comes along with having on the investment when one acquires their income and savings.
Abstinence theory
This theory argues that interest is the reward one acquires when they abstain from the present ingestion. People often save to have more money so that they can acquire capital goods; however, savings imply that they sacrifice the current consumption — also, not many people like such abstinence. So, it makes them pay for the interest to induce them for preceding for the present con...