Significance of Interest Rates to Policy Makers and Other Economic Actors - Essay Example

Topic: Critically discuss the determinants of the rate of interest and the significance of interest rates to policy makers and other economic actors. Introduction Interest rates primarily determine the functions of financial markets, in Economics it is termed as reward for using capital better known as return on capital. It is fair to say that interest is the cost of using capital. Capital is nothing but a factor of production and it can be in more forms than one, for instance machinery, goods or any other material asset employed in generating output. A lot of investment goes into the purchase of capital goods and the most integral thing here is funds. Funds is also called as financial capital, The supplier of this financial capital to the entrepreneur so that he may invest it in real capital assets like machinery and others, will be paid on the market rate of interest by the entrepreneur. It is described as interest in percentage of the amount of funds borrowed. This is a simple explanation of the rate of interest. Let's review some definitions of the rate of interest to comprehend the concept (Unit 3). Bannock et al has defined the rate of interest as the price a borrower has to pay to enjoy the use of cash which he or she does not own, and the return a lender enjoys for deferring consumption or parting with liquidity (1998:346). According to Mike Moffatt, "The interest rate is the yearly price charged by a lender to a borrower in order for the borrower to obtain a loan. This is usually expressed as a percentage of the total amount loaned". (http://economics.about.com/cs/economicsglossary/g/interest_rate.htm). Thus, interest rate is the annually charged in percentage on the principal. Interest is derived by dividing the amount of interest by the amount of principal. Inflation and the government policies play a crucial part in bringing fluctuations in the interest rates (www.investorwords.com/2539/interest_rate.html). It is pivotal to know that although each bank decides its interest rates by its own on the loans sanctioned but actually local rates are almost same in different banks. When there is inflation, interest rates go up because of increased need of credit, tight money market, or for the reason that banks' need to maintain a higher reserves. Any of the reasons affect the business activity and the stock market as well. Businesses in need of funds have to pay more for the same amount of borrowing and the investors would prefer to invest in bank deposits or newly launched bonds than purchasing shares (http://www.businessdictionary.com/definition/interest-rate.html). Determinants of interest rate levels Parameters of interest rates (Upton, 2009) are defined by supply and demand when the supply of money is equal to the desire of economic entities to borrow. Further, it is important to know the factors that affect supply and demand. Since interest is a pay back for delaying consumption, a higher rate of interest will accrue in more supply of funds. We can say that in different circumstances an interest rate may not result in same supply of funds. In different countries people don't have the same concern for consumption, as one can perceive that there are different savings rates. When economic conditions are not stable, people are more induced to save, as seen in their behaviour during "depression generation". Demand (Upton, 2009) on the contrary, depends on the availability of investments. At the low interest rates investments provide more margins. With the positive growth environment and technological advancement, demand for investment will boost. Other things that impact future growth are rate of increase in population, labour force, and education and skill standards. On the whole economic environment and production environment determine the level of demand for funds. The interest rate is (Upton, 2009) determined by the economic and other factors causing increase in the capacity of consumption. The rate of increase in the capacity of consuming is known as the "real" rate of interest. The "nominal" rate of interest checks the increase in dollars. Money is the yardstick to measure the capacity of consumption, which gets affected due to inflation. Inflation brings down the buying capacity as the purchasing power of money decreases. Thus, it is the real rate of interest that plays a crucial role in deciding demand and supply of funds, the nominal interest rate carries a premium to reward for the loss in the buying capacity. The nominal interest rate is stated as the real rate of interest added with an inflation premium. Upton (2009) states that when rates of inflation are quite meager, the inflation rate itself is a better guess of the premium needed; its last term is mostly not considered but the last term becomes crucial when the rates of inflation are higher, and need to be included. For example in the 1980s due to a certain extent the levels of interest rates were higher because of the impact of actual inflation. Taking the hints from the Deutsche Bundesbank Monthly Report (July 2001) regarding the movements and determinants of real interest rates, real interest rates play a very constructive part in the development and long term growth of the economy. In many theoretical models, the real interest rate gap (the difference of the actual from the neutral real interest rate) is used as a parameter of a country's strictness shown through its monetary policy. Practically, it is not viable to apply the real interest rate gap in the monetary policy. Uncertainty arises due to absence of dependable method of calculation. Even in a liquid market of inflation linked bonds, the problem cannot be fully resolved because indexation requires at least three months. Even more difficult is to measure the neutral reference rate. The latest macro-economic models are far from satisfactory. Even then, Deutsche Bundesbank Monthly Report (July 2001) real interest rates provide crucial data of investment conditions of the capital market and the financing conditions of the economy. Other monetary policy indicators must also be considered, specifically the money stock. Central banks can have direct impact on the interest rate only for a short time span but the long term direction of the central banks' impact is doubtful. Tristani (2009) has discussed the natural rate of interest regarding the future course of monetary policy among other variables, showing that the model uncertainty, which is based on the modeling approach that monetary factors and their uncertain behaviour can create doubts in the minds of people regarding savings. It can create problems in measuring the natural rate of interest and employing this as a policy indicator. This uncertainty of the future course of monetary policy positively links it with inflation. The concept of interest, according to Oster (2003), takes into consideration the theories of time preference, marginal productivity, liquidity preference and loan able funds. Due to divergent views on interest, it can be classified as real and monetary types. Real theories of interest are long run and monetary theories are short run theories of interest. In real theories, interest incurs due to real absence; it is a yield on real capital while in monetary theories, which are short run theories, the monetary rate of interest is the price of borrowing money and trading securities and the yield occurs on loaning money and buying securities. In other words, the real rate of interest depends on the supply and demand for the actual or real savings while the monetary rate of interest depends on the demand for and supply of money Greenwald 1982: 536, as cited by Oster (2003). Government policy, according to Upton (2003), also impacts interest rates being a policy instrument of the government. In any country, the central bank there has some control on the circulation of money. It impacts the interest rates. As the money in circulation increases, it instantly affects the economy by registering a decrease in interest rates caused by the increase in the supply of money. However, in the long run, the increase in the circulation of money causes inflation. Anticipation of inflation increases the interest rates. As a policy initiative when the government wants to contract the money market by limiting the growth of money, it results in decrease in the supply of money and increase in interest rates as a consequence. Economic growth as a result can stagnate, which can finally lead to a downfall in the interest rates. Taking the example of the Federal Reserve, Upton (2003), it has been following two policy objectives, i.e. growth in money and interest rates. The Federal Reserve has only a limited control over these two variables. In an ever-changing economy the like of America, it is not possible to control money supply and inflation. The instruments of monetary policy affect the short term interest rates directly but the long term securities get the impact of change in interest rates from the reaction the money market makes on government policy and its economic impacts. Economic forces affect the levels of interest rates while government policy has a limited impact on the economic forces. Foreign markets as well as foreign interest rates have also become a deciding factor. Borrowing in foreign market has become common and lenders are also willing to lend in foreign markets. As a consequence, fluctuations in interest rates get aligned world-wide. The impact of country-specific forces over the local money market gets reduced. Let's take a view of the change in interest rate and inflationary impact on the U.S. market because of the housing fiasco. According to Minadeo & Sawyer (2007), there has been a global savings binge, which has been the reason of low levels of interest rates in the U.S. Actually, it has helped the U.S. economy to recuperate speedier from the negative impacts of globalisation as jobs and manufacturing units have been changing base to developing countries because of cheap labour there. The increased interest rates in the mortgage business that brought recession also had some countervailing effects. The short term effects of increased interest rates were although pinching but it also happened to be the cause of dollar appreciation. It cut down the prices of imported goods and helped in bringing inflation under control. Natural cycle was responsible in creating long term market equilibrium. It is expected that markets would stabilise with the control on the consumption level in American economy. Incidentally, in Bahrain, a member state of GCC, the average interest rates are stable although rising in the U.S., as per the Bahrain monetary Agency (BMA). But interesting thing is that interest rates are going upward on deposits. Commercial banks in Bahrain have increased short term deposits' interest by 218bp in the last seven fiscal quarters. It has resulted in the margin decrease between the fixed term savings and personal loans by 4.89%. An upward trend has been noticed also in the public debt instruments and the money market instruments (http://www.ameinfo.com/66927.html). According to Mr. Ahmed Jassim Bumtaia, Director, Economic Research, at the BMA, "As a central bank, the BMA monitors the movement of interest rates internationally and the impact of such movement on domestic rates". A comparison between the interest rates determined by the banks in Bahrain with their U.S. counterparts becomes logical, as the Bahraini dinar (BD) is linked to the US dollar. One can accrue from the fact that interest rates will bear the impact of the prevailing U.S. market rates due to the reason that BD is linked to the US dollar. A decrease in the interest rate was notices for the given time period in the personal loan and business loan while interest for long time period loans increased between March 2005 and June 2005. Also noticed was decrease in the margins between fixed term loans and personal loans as well as business loans. BMA found alignment in the interest rates of the U.S. and Bahrain. Further, an increase in the interest rates on BMA's 3-month Treasury Bills and Sukuk Al-Salam (Islamic bonds) was noticed. It also showed increase in the Repos (http://www.ameinfo.com/66927.html). Qatar, another GCC member state, has been into selling of bonds to control inflation. The central bank there has increased the percentage of reserved money as a monetary policy measure. It is expected that the monetary policy would help Qatar in reducing the aggregate demand that will result in deflation. Inflation has been on the increase due to increase in property rents and prices. Property market scenario has changed the consumers' direction from saving to consumption, prompting borrowings resulting in price hikes. Through a set of government policies to control supply by issuing bonds so that demand slows down and liquidity of money is reduced. The government can also apply supply side policies like reducing taxes so that prices come down, which will automatically bring down the rate of inflation (http://welkerswikinomics.com/students/p=344). Different interest rates There are different interest rates, according to Upton (2003), depending on the type of borrowings, which include saving account rates, personal loan rates, credit cards rates, mortgages, corporate bonds, and many others. Reasons of borrowing for investors, business firms, and individuals are different, that's why interest rates are different. Economic variables determine the common level of interest rates but particular interest rates levels are determined by different other variables. A number of factors affect interest rates but they are classified on the basis of maturity period, quality, and tax status. The term structure of interest rates Interest rates, as per FINC 4320 (2004), depend on the term of loan maturity - its time period as per the arrangement. It can be described by a yield curve exhibiting interest rates for different maturities. There are three common theories regarding the term structure of interest rates. 1. The Pure Expectations Theory (PET), 2. The Liquidity Premium Theory, and 3. The Market Segmentation Theory According to Upton (2009) in the Expectations Theory, the interest rates in the long run are contingent to the chain of short term interest rates anticipated for that definite time. Time duration is not an issue with the lenders; returns should be same whether there are ten yearly loan contracts or one loan contract for the period of ten years. If this strategy doesn't work, investors would prefer a different way where adjustment could be made in interest rates to gain the targeted wealth. Investors can opt for other alternatives like arbitrage if the above relationship of investing in either one or ten different contracts doesn't work. In the new investment starting from net zero, the yield curve would move up in case short term interest rates are anticipated to increase in future. If a decrease in the interest rates is anticipated, the yield curve would move downward. As per the term structure of interest rates, the second approach, according to Upton (2009) called the "liquidity theory" indicates that investors are concerned on the time period of a loan commitment. The reason being a long period loan is riskier than a short period loan. Future path is uncertain and there are more chances of negative outcome. Investors won't prefer to lock their stock for a longer term unless there is a "liquidity premium" to cover the risk involved. In such an arrangement, the yield curve would always be going upward. Empirically, this theory cannot be rejected of decreasing yield curves if taken along with other theories. If the liquidity premium is laid over to cover the investor's risk, anticipating that short tern interest rates will go down in near future, the yield curve still would go down but would be less sharp. The third approach, according to Upton (2009) is based on the "segmented markets" theory, functioning on the basis of determination of interest rates on demand and supply. The basis is that lenders and borrowers would prefer an environment of their liking, in other words their preferred term structure. Both, the lenders and the borrowers would like to minimise their risks by equaling the maturity of their assets and liabilities. A lender whose liability would become due in the next five years, for example, takes the risk by lending for the same time period. Similarly a borrower whose investments would pay after the five years period would borrow for that maturity period only. Thus, both the borrowers and lenders would prefer not to leave their maturity timing and not involve themselves into arbitrage. Interest rates would be determined by the demand and supply of that maturity period only. All of these theories on term structure of interest rates, according to Upton (2009), apply only partially. Empirically seen since the Second World War the yield curve has been going upward mostly with long term interest rates than short term rates. Yield curves taking u-turn in long term rates have been lesser in comparison to short term rates. Otherwise also, long term rates are not as volatile as short term rates. The quality structure of interest rates According to Upton (2009) this is related to and depends upon the degree of doubt on getting timely return against a loan. If there is some doubt on the surety of receiving the given amount, a higher rate will be asked by the lender, called "risk premium". It is not the total failure on the part of the borrower; late payment is also a default payment. Such loan structures where scope of irregularity in payments is minimum, is known as of high quality. According to Upton (2009) the percentage of risk premium will depend on the recurring chances of a problem, degrading the quality of a term loan. Treasury obligations of the U.S. government having least risk are of the highest quality to be followed by state governments issuing bonds and local bonds, known as "municipals" rated secondary to treasury obligations. Difference in quality is only of some degree. The same variation in quality can be seen in some corporate bonds given ratings for quality by the private investment companies the like of Standard & Poor's. Such ratings are crucial in determining interest rates, called "yield" that is the gain of investors. Certain bonds have a below average rating, and are called junk bonds, issued on higher interest rates. The quality parameter is same also in the matter of bank loans. Prime rate is given to clients with clean record of payment. Where risk is higher, interest rate is also higher as in the case of credit cards; home loans are more secured than car loans as they carry collateral. Another important feature of a loan is its liquidity. A liquid asset is that which can be changed into cash. So, illiquid loans carry higher interest rates. These days certain types of loans are "securitised" by getting packed into such portfolios that issue securities. It reduces the lender's risk; therefore, a decrease in the interest rate is seen. Tax Status According to Upton (2009) reason for variations in different interest rates between the municipal bonds and corporate bonds is the tax rebate available to buyers of municipal bonds. These taxes reduce the real rate of interest. As these interest rates are real for both taxable and non-taxable debts but it doesn't apply to all investors as there are different tax rates. The after-tax rate of return on municipals will be higher for investors with high tax rates; the same holds true for investors with low tax rate on corporate debt. Mortgage based home loans also enjoy tax deduction, which reduces the interest rate. Conclusion The paper threw light upon the different determinants of interest rates and the importance of interest rates. The impact of globalization has had a telling impact on the interest rates as well, the inflation level in one country does not remain limited to that country, and a classic instance is the current recession which had a bearing on almost all global economies. One thing is clear that government can rein in negative economic tendencies through monetary policies only to a limited extent but it can help in achieving the desired end to some degree. References: 'Bahrain interest rates on loans stable despite rising US rates', 06 September 2005. Available from: www.ameinfo.com/66927.html. [Accessed 25 September 2009]. 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Available from: http://www.ingentaconnect.com/content/bpl/jmcb/2009/00000041/00000007/art00007;jsessionid=h2n398snd3eq5.alexandra [Accessed 25 September 2009]. Unit 3: 3.1. (2008) Introduction: the determinants of interest rates. The Basics of Financial System. [Online]. http://www.egyankosh.ac.in/bitstream/123456789/25886/1/Unit3.pdf [Accessed 25 September 2009]. Upton, David E. (2009). Determinants of interest rate levels. Available from: http://www.referenceforbusiness.com/encyclopedia/Inc-Int/Interest-Rates.html [Accessed 25 September 2009]. Read More