Determining Interest Rates
Understand more about interest rates
Definition of interest: the cost of borrowing or alternatively the reward for saving.
Nominal vs Real Interest Rates
Nominal interest rates are interest rates that fail to account for inflation.
Real interest rate does take into account inflation.
Therefore…
Real interest rate = Nominal interest rate – Inflation rate
Nominal interest rate = 7%
Inflation rate = 2%
Real interest rate is therefore 7 – 2 = 5%
There are 2 theories that determine the interest rate of banks.
1) Loanable Funds Theory
2) Liquidity Preference Theory
Loanable Funds Theory
In the loanable funds theory, the interest rate is determined by savers and borrowers. Savers represent the supply of loanable funds (they provide this to the banks). Borrowers represent the demand for loanable funds. Therefore, this creates a market for loanable funds and the interest rate acts as the price.
[Diagram]
This theory shows that with higher interest rates, borrowers will not be attracted to the market, but savers will. Therefore, interest rates will need to fall to encourage more borrowers to borrow money.
The equilibrium interest rate will be the interest rate that matches borrowers with savers’ money perfectly.
Liquidity Preference Theory
In this theory we assume a fixed money supply in the market. In this theory, a person can choose to hold their wealth in either liquid form (money) or bonds (illiquid asset).
If you hold your money as bonds, it means you can make a profit from the interest you get back. However, the risk is that the value of your bonds may go down as well as go up.
If you hold your money as cash, it means that you will not make a profit, but your wealth is likely to stay the same because cash retains its value (it’s a store of value remember).
If interest rates are high, it means that bonds become more attractive. You can instead hold your wealth in bonds and earn a profit when you do so.
If interest rates are low, it means bonds are less attractive and money is more attractive.
We can show this on a diagram:
[Diagram]
Therefore, the result of this theory is that:
High interest rate = Low demand for money, higher demand for bonds
Low interest rate = High demand for money, lower demand for bonds
The interest rate is determined by the equilibrium between the supply of money (MS) and demand (LP).
In summary, we have learned:
Nominal vs Real Interest Rates
Loanable Funds Theory
Liquidity Preference Theory
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