Interest Rates - Chapter 14

[Actuarial Hopeful]

Hi there,

I am having some trouble fully understanding the concept of interest rates, and what implications they have on the economy. Please can someone comprehensively explain exactly what causes a change in interest rates, and why? Does a change in money supply affect interest rates, or is it vice-versa?

Also, what is the exact chronology of events, and why? For example, does a change in money supply affect interest rates, which in turn affects demand for money, which then in turn affects the national income?

Thanking you for your help. It will be extremely appreciated.

 

[Margaret Wood]

interest rates

Hi

Firstly, the money market ...

The process of increasing the money supply reduces interest rates and increases the demand for money. The central bank buys bonds on the open market (and hence gives people cash which they deposit in banks which then increases the money supply). The increased demand for bonds in the market increases the price of bonds and hence reduces the return on the bonds, ie reduces interest rates. The increase in the price of bonds and the decrease in interest rates encourages people to part with their bonds, ie encourages them to hold cash instead, ie increases the demand for money.

Then, the effect on the goods market ...

When interest rates decrease, this causes an increase in aggregate demand. Consumption and investment will increase as it is cheaper to borrow; and net exports might increase if the decrease in interest rates causes a depreciation of the currency. The increase in aggregate demand will then increase output/income as long as the economy is not at full capacity.

 

[Actuarial Hopeful]

Thanks for your answer.

One final thing - I can see why an increase in the demand for bonds would obviously lead to an increase in price. Consequently, it seems pretty logical that an increase in the price of bonds will decrease the return, as obviously one would be paying more but receiving the same amount in return (i.e. the coupon payments and principle). However, please can you clarify exactly why this increase in the price of bonds leads to a decrease in interest rates?

 

[Margaret Wood]

The interest rate is the yield or the rate of return on the bond. Remember that the price of the bond is the present value of the bond. This is found by discounting the future cashflows from the bond at the appropriate interest rate. So, if the price increases, the interest rate must decrease.