Role of Interest Rates in Contemporary Economies - Research Paper Example

The Role of Interest Rates in Contemporary Economies The Origin of Rate of Interest: Since the beginning of man whence he took interest in trade and commercial transactions we see his initiative in the 'usury' or commonly known as 'Interest' in the course of business dealings. In the early history when money was not introduced, we find the loans were advanced in wheat grains and other crops or other barter goods in shape of loan of for instance100 Kg wheat would be returned on next crop by the debtor 120 Kg. Such a fixed rate of return was received by the creditor after a year. At the time of introduction of coins, money in the early stages of history was loaned at a fixed rate of interest. We, however, discover one distinctive feature that the interest was abhorred in early stages to present day, and was considered as curse for the growth of economic activities in the underdeveloped countries. All the monotheistic religions i.e. Judaism, Christianity and Islam looked interest with contempt; where the Judaism and Christianity compromised with its significance as stimulating force for economic prosperity, Islam still treats it as a ' war against God' and practicing Muslims dislike the lending and receiving of interest . In our early history the Greeks were considered as highly civilized nation. Lending money at interest was forbidden by the Greeks. Aristotle whose powerful indictment greatly influenced the later nations condemned the taking of interest in very strong words. He compared money to a barren hen which laid no eggs. According to Aristotle, the object of the use of money was to facilitate exchange, and the fuller satisfactions of human wants. According to him this was the most natural purpose of money; money could not be used as the source of accumulation i.e. to increase at interest. So accumulating money at interest was the most unnatural of all ways of making money. A piece of money cannot beget another piece, and hence it was unjust. Plato too condemned interest. Similarly Roman Empire prohibited the charging of interest, and they were first nation to enact laws for the protection of debtors. Gradually prohibitions against usury began to be renewed in Europe. In England the ban was renewed in 1545, during the reign of Henry VIII. It was only during this period the word usury began to be replaced 'interest'. (Homer 1996) The Prerequisites to the Rise of Interest Rate: In the underdeveloped economies the demand for capital is great while the supply is very limited as compared with developed economies. Marginal productivity of capital is very high in developing countries and hence the rate of interest is also high. Some political factors also contribute to high rate of interest in poor countries. As a high risk of bankruptcy is involved the higher rates of interest are claimed by the lending agencies. Where there are possibilities that capital would earn greater reward for the investor, he will be willing to pay higher rate of interest keeping in view the higher degree of capital productivity and better power of payment of interest. In such situation the rate of interest will rise. When a loan is required for a longer period the money lender would prefer to advance loans to debtors at higher rate of interest as the money lender/creditor have to part with their cash assets for a long period which involves greater risks than the short term loans. Increase in trade and business activities creates healthy atmosphere and it also creates demand for capital to greater extent and in such circumstances the expectation of higher rate of interest can not be ignored. The rate of interest will rise due to excessive demand of cash resources. When the economy is under inflationary pressure, it is indicative of the fact that the higher rate of interest prevails in the economic activities of a country. In such situation the interest rates will also rise The Nature and Necessity of Interest Rates: Why should interest be paid at all In the Middle Ages Money was regarded as barren and hence interest, it was thought, was not justified ethically speaking. Some people even now favor the abolition of interest in every form. Without entering into ethical controversies, let us look at the matter from the economic point of view. Is payment of interest justified on economic grounds Since capital is productive, we can say that interest can be paid. But should it be paid What will happen if is not paid We can enforce a Zero rate of interest only if capital loses its character of scarcity. As it is, capital is relatively scarce to demand for its services. There are so many alternative uses to which capital can be put. It is the rate of interest which determines to which uses capital should be put. Some uses have to be sacrificed in order to supply capital to more pressing uses. Even in a socialist society interest cannot be abolished even though it may not be paid to private individuals. Even there, through its instrumentality, priorities regarding the use of scarce capital resources for various possible employments will have to be decided. The order of priorities in a socialist State will probably be different from the one in a capitalist society, but interest will perform its function all the same. It has the same function as the function of price, i.e. it restricts demand to the supply available. It enables capital to be apportioned between competing demands of alternative uses. Through its instrumentality those uses which promise the highest future returns receive the first consideration. Of course, the criterion of the highest future returns will differ in a capitalist society from a socialist society. In the former, expectation of profits for private entrepreneurs and in the latter the concept of welfare on the part of the planning authority will determine the priorities in investment. You cannot abolish interest; you can socialize it if you socialize capital. As long as capital is not socialized, interest must be paid to keep up the stream of capital accumulation. (Salvatore 1987) Forms and Functions of Interest Rates and Their Relative Significance: The part played by the rate of interest on different investments determines the rate of interest by providing capital to each sector. A person who saves money can invest it by acquiring various forms of assets, the most important of which are (i) Bonds, (ii) shares, (iii) bills and (iv) money balances. (i) Bonds. Bonds are long term, fixed interest bearing securities. They give their holder the right to a fixed money income. The most typical example is first- class Government Bonds, also called gilt-edged securities. If a person lends Pound 100 to the British Government, he may get the British Government securities bearing 3 percent interest rate. This will give him an income Pound Sterling 3 a year as long as he holds the security. (ii) Bills. Bills are short-term, fixed interest securities. Bills may be private bills issued on account of trade or financial transaction by private individuals or corporations or they may be public bills issued by the Government. The latter are called Treasury Bills issued by the Government. Through their sale the Government borrows money for short periods, usually three months. For instance the Government may sell Treasury Bills at $98 to be repaid after three months at $100. This means a yield of $2 on $98 in three months or $8 in a year. (iii) Cash Balances. Holding one's resources in the form of cash in a bank involves practically no risk of loss but the money earns no income. Lending of money even for a short period involves some risk. Cash in hand is also convenient for carrying on day-to-day transactions and to meet emergency expenditure. Hence people do hold some of their resources in "liquid" form. The payment required to induce people to part with "liquidity" in this sense is usually represented by short-term rates. In times of financial panic these rates go up because firms are anxious to borrow money for short periods to meet their obligations in order to avoid bankruptcy. This increases their desire for liquidity.( Keynes 1997) The Factors Which Influence Interest Rates: The factors which influence rates of interest consist of differences in the degree of risk involved and inconveniences suffered by the lender. Pure interest, however, may be different in different investments when the market is not the same. This may be due to: (a) Differences due to distance: People are usually more willing to invest their Capital nearer home than at a long distance. This may create difference in supply and demand due to comparative immobility of capital. (b)Differences due to time: If people have to part with their money for a longer period, they expect higher rates even though risks and other factors are the same. Of course, if money is lent for very short periods and has to be relent again and again, the inconveniences of management will increase gross interest. But that will not be interest. Differences in gross interest, in addition the causes arise due to following factors: (i)Differences in social esteem: A person with greater reputation for integrity can borrow at lower rates. This is partly due to the element of lower personal risk in view of the lender's trust on borrower. (ii) Differences in productivity: When capital can earn greater reward for the producer, he will be willing to pay higher interest. But here also usually such trades are more speculative and higher rate can be attributed to higher risks. Moreover under perfect competition, marginal product of capital and hence pure rate of interest tend to equity. Higher rewards in particular employment, if not justified by greater risk or inconvenience, tend to disappear through forces of competition. But if competition is imperfect, such differences may persist. The productivity of capital may differ in different countries. In new countries, for instance, the demand for capital is great while the supply is very limited as compared with old countries. Capital thus has a high marginal product and interest is high. This is due to the immobility of capital over distances. Partly it is due to greater risk. In the latter case, it is gross interest which will be higher, not net interest. Thus differences in interest rates can be reduced to differences of inconvenience or risks of lending except in cases where we are not dealing with the same market. Pure interest tends to be the same in the same market. (Samuelson 1976) There are various other influences which change the rate of interest, both in the short and long period, either by causing greater demand or by influencing the degree of scarcity. Increase in business activity creates demand for capital and raises interest. Bad harvests or other influences affecting incomes reduce the supply of loan- able funds and again raise interest. Political factors also influence the rate of interest. Long period rates are affected by long period factors like change in the size of population, change in saving habit of the people. Short and long period rates, however, are not independent of each other. (Keynes 1976) The Structure of Interest Rate: Different views are advanced by the economist on the subject of interest that why interest is paid or what determines the rate of interest. Senior thought that interest is paid to compensate for the pain of 'abstinence' on the part of the saver. The Austrian School advanced the view that interest arises because one prefers present goods to future goods, because present satisfactions are more urgent and more certain. Interest is discount paid to encourage postponement of consumption. Fisher uses the term "time preference" as the central point of this explanation. According to Keynes, interest is the reward for parting with liquidity for a specified period. Liquidity preference of individuals is the desire to hold their assets in cash. This may be for personal reasons, business reasons, or speculative reasons; particularly the last is more important. If the supply of money is given, interest will be determined by the demand, represented by liquidity preference. An increase in liquidity preference raises the rate of interest and decrease lowers it. Keynes' theory doest not define consistently what he calls money. He makes interest independent of demand for investment. Actually interest is not independent of what Keynes called the marginal efficiency of capital. Interest is determined by equilibrium between supply and demand. Marginal product takes into account both these factors. It expresses the relationship between the degree of scarcity (or supply) on the one hand and the alternative uses to which capital can be put (or demand) on the other. On the demand side, each firm pushes the application of capital until its marginal product equals interest. From this the demand schedule for capital of all the firms can be built. The supply of loan able funds depends upon savings which depend upon power to save and will to save. Higher rates of interest in the net tend to stimulate saving. Supply and demand with their equilibrium will determine where the rate of interest will stand. Interest can be explained in terms of scarcity principle when we are thinking of real capital instead of loan able funds. Capital resources are scarce; they have to be distributed among competing demands ultimately based upon consumers' choices for different assortments of goods. Interest thus reflects the degree of scarcity in which capital stands in relation to other factors of production, when contributing to the consumers' competing demands for various assortments of goods and services. Rate of Interest Causing Credit Crunch in Economy: The ultimate objective of an economic system is to increase the welfare of its population. Interest rates provide the vital support to national economic policies in achieving this goal. Before the advent of central banks, national exchequers were responsible for handling both fiscal and monetary matters of the economy. Modern economic thinking emphasizes the independence of the monetary authorities in order to regulate the bank rate in such a judicious manner as to minimize the inflation which is inherent in monetary institutions due to their power of creation of money. An undue zeal in using this power can easily reduce the welfare of the economy by creating hyper inflation. Similarly, an unwise reluctance in providing needed monetary accommodation can also reduce the well being of economic agents by creating a credit crunch. The goal of interest rates are always multiple, these are usually enshrined in the law under which the central bank functions. Even if a central bank of a country has a single objective of maintaining price stability through regulation of its bank rate policy which ultimately governs the interest rates in the financial institutions of the country; leading to both an economic activity of the country and saving it from embarrassing situation of financial crunch as witnessed in last year the first ever run on a U.K bank in almost one hundred and fifty years. The bank- Northern Rock which borrowed whole sale and loan retail one fine morning found that it had nothing to lent because of credit crunch unleashed some weeks ago by the collapse of "sub-prime" mortgage market in the U.S. unexpectedly the government or more precisely the chancellor of exchequer moved in quickly to underwrite with the tax payer resources of the depositors money. In effect, a nationalization of private money it was a three pronged move by the chancellor, the bank of England, and financial services authority. The shares of Northern Rock which only a couple of months ago were being sold at 700pa piece had tumbled to less than 300p as the depositors queued up in front of the bank to withdraw their money. The government itself appeared to be trying to make a killing at the cost of a down and out bank as its under- writing came at a very high cost, as high as 7% in interest rate- which has perhaps described as a penal rate. The above situation explains that interest rate plays pivotal role in productivity of capital in regulating the stock exchanges and in facilitating the investment opportunities in contemporary economies, and are the source of economic well being of the people at large. . (Riaz-udin 2005, p4) The Role of Interest Rates in Business Fluctuations as an Instrument of Monetary Policy: Interest rates play an important role in business fluctuation as instrument of monetary policy. Central Bank of a country through its Quantitative Credit measures checks inflationary trends and strives to bring stability in economy. Bank Rate Policy is one of the major instruments which are closely linked with interest rates prevailing in the economy. Interest rates charged by commercial Banks on the loans advanced to their customers as well as the interest rate paid by them on their savings deposits are affected by the bank rate changes. Similarly interest rate paid by the government on its treasury bills and bonds is also influenced by the bank rate. Therefore, whenever central bank wants to raise or lower the interest rates in the economy, it can achieve this goal by raising or lowering the bank rate. If the central bank for the sake of controlling inflation in the economy, wants to decrease the supply of credit, it raises its bank rate. When bank rate rose, then commercial banks are forced to raise their interest rates, because they realize that the occasion of borrowing from the central bank, they will have to pay a high rediscount rate. With the raising bank rate, borrowing becomes expensive; therefore, the customers of commercial banks borrow fewer amounts because many economic activities, which were profitable previously, now no more remain profitable because of high interest costs. In this way the credit issued by commercial banks or the loans advanced to their customers decline. Thus, total volume of purchasing power in the economy decreases, which helps to control inflation. Conversely, for the sake increasing output and employment in the economy or for the of remedying recession the central bank lowers its bank rate and encouraged by it commercial banks lower their interest rates on the loans extended to their customers. Borrowing becomes cheaper as a result of which many activities which were not profitable previously now become profitable at lower interest rates. Under these circumstances customers of the commercial banks borrow large amounts. Thus the supply of credit in the economy increases, which helps to increase output and employment and so recession, is cured. (TAUSSIG 1923) References Homer, Sidney. 1996, A History of Interest Rates, 3rd edn, Rutgers University Press, New Jersey. Salvatore, Dominick. 1987, Theory and Problems: International Economics, 2nd edn, McGraw-Hill, Inc, Singapore. Samuelson, Paul Anthony. 1976, Economics, McGraw-Hill, Inc, Singapore. Keynes, John Maynard. 1997, The General Theory of Employment, Interest, and Money, Prometheus Books, New York. Keynes, John Maynard. 1976, A Treatise on Money, Ams Pr Inc, New York. TAUSSIG F. W. 1923, Principles of Economics, 3rd edn, v.Crammers, New York Riaz-udin, Riaz. 2005, Monetary Policy and Inflation, Dawn Economic and Business Reviews, 5 Sept, p.4. Read More