A Citizen’s Guide
to Interest Rates
What most people don’t know about
what really makes our economy go.
(…… but should)
The Secret Life of
Interest Rates
• The most important thing that interest
rates do is to act as signals for the market.
• Signal to save or borrow and spend.
• ir also serve to ration the available supply
of money to those who are willing and able
to use it most efficiently in the long run.
• Act as an automatic stabilizer to inflation.
Rationale
• Much of the internal doings of the U.S. (and
World) economy have to do with monetary and
fiscal policy decisions which affect interest rates.
• Any understanding of Economics is incomplete
without knowledge of how interest rates affect
and are affected by every other component of
the economy.
• Savings and Investment in Capital are where the
individual interfaces with these policies.
• Most individuals understand interest rates
imperfectly if at all.
Key Topics Regarding ir
• Identify models that should be used to
demonstrate economic theories and
discuss when to use which model.
• Identify important concepts and how to
apply them.
• Discuss ir using appropriate vocabulary
balancing jargon with concrete
explanations in plain English.
Key Concepts
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What are Interest Rates?
Real vs. Nominal
Money Supply and the Federal Reserve
Money Demand
Loanable Funds Market
Fiscal policy and its impact on interest rates
Crowding-Out Effect
Bond Market
Foreign Capital Injections and Leakages
The Relation Between Capital
Investment and Interest Rates
• Interest Rates DETERMINE the quantity of
Capital Investment and Savings in the Economy.
• Interest is the Opportunity Cost or “Price” paid
for the use of money
• Borrowers pay lenders for money to be used
now, and repay later with interest
• Savers earn interest because they are letting a
lender use their money now
• Lenders are financial intermediaries.
• Interest rate is stated as a percentage
Real ir vs. Nominal ir
• Appropriate abbreviations for Interest rate
include “ir”, “i”, and “r” (always lower-case)
• Nominal: loosely means “in name only”
• Nominal ir discussed in terms of current
price level
• Real: loosely means “adjusted for inflation”
• Real ir discussed in terms of actual
purchasing power.
How Nominal and Real Relate
• (Calculate)
Nominal ir
– Inflation Rate
= Real ir
• If Nominal ir goes up, Real ir
doesn’t necessarily increase.
• If Real ir goes up, Nominal ir will
follow.
Graphic Models for ir
• Interest rates play a role in various graphic
models, the key is to figure out if they are
nominal or real ir.
• The Money Market Model is used to
discuss the supply of money as defined by
the FED. (nominal ir)
• The Loanable Funds Market is used to
reflect the saving and borrowing habits of
the private sector. (real ir)
Money Market Model
• Used to target the
Fed Funds Rate
through monetary
policy.
• Nominal ir
• Should be used in
conjunction with
AD/AS and
Investment Demand
models (Next Slide)
Money Market Model
Nominal
ir
MS
MS1
ir
ir1
MD
QM
QM1
Quantity of Money
Money Market Linked to Demand
for Capital Investment
Nominal
Expansionary Policy
MS
MS1
Investment Demand
Nominal
ir
ir
ir
ir1
I
MD
QM QM1
Quantity of Money
I
I1
Quantity of Capital Investment
Investment Linked to AD/AS
Investment in Capital
Expansionary Policy
Price
level
Nom
-inal
SRAS
ir
PL1
ir
PL
ir1
AD1
(C+I1+G)
I
I I1
Quantity of Capital Investment
0
AD
Y Y1
Real Gross Domestic Product
(C+I+G)
Loanable Funds Market
• The Demand Curve for LF
represents private demand for
Loanable Funds.
• The Supply Curve for LF
represents private savings.
• LF model represents the real
ir. (abbrev. “r”)
• Supply of LF (savings) sets the
Prime Lending Rate.
• Government borrowing to
cover deficit spending will
move DLF to the right.
• Changes in the savings habits
of the private sector shift SLF
Loanable Funds Market
Real
ir
SLF
r
DLF
QLF
Quantity of Loanable Funds
Loanable Funds Theory of Interest
• The supply of loanable funds comes from
savers who deposit money in banks.
• Supply is positively-sloped because
people need an incentive to delay current
spending.
• Demand is negatively-sloped since higher
ir discourage borrowing and spending.
• Government borrows money from this
market when taxes don’t cover the bills.
Control of Interest Rates
• The majority of influence on interest rates comes
from the private sector.
• Rates react to changes in the individual desire of
private citizens to consume or invest in capital.
(or to save…)
• Investment spending and the interest sensitive
components of consumption spending are
inversely related to interest rates.
• The desire to save is positively related to ir.
Definitions of Money
• The Money Supply is broken down into
three categories:
M1: Cash, Currency, Checkable
Deposits, NOW accounts, etc…
M2: Savings (under $100,000), Short
time deposits, CD’s, MMF’s, etc…
M3: Deposits in excess of $100,000
and other long time deposits
The Demand for Money
• This is a uniquely Macroeconomic
concept
• At any given time, there is a finite
quantity of money in circulation
(M2 is Inelastic).
• The transaction demand (M1)
depends on GDP because
incomes = expenditures.
Fiscal Policy
• Most expansionary government spending
programs are financed through borrowing.
• Budget deficits will increase the demand
for loanable funds and cause real ir to rise
• Contractionary fiscal policy will cause
budget surplus
• Budget surplus will reduce the demand for
money and reduce interest rates
Deficit Spending
• Government demands loanable funds to
pay for deficit fiscal spending
• By increasing the D for LF, the real ir
increases. Loanable Funds Mkt.
Real
ir
Qty. of Loanable Funds
Crowding Out
• The increased real ir caused by deficit
fiscal spending causes a decrease in
private Investment spending and the
interest-sensitive component of
Consumption spending.
• This lost investment and consumption is
said to have been crowded out.
• Crowding out is an effect, never a cause.
Crowding Out and AD/AS
Deficit Fiscal Policy
Real ir
SLF (Private Savings) Price
AD shifts to AD1 when G increases
Then shifts back to AD2 as I falls due to
the increase in interest rates.
Level
r1
Pl1
r
Pl2
PL
SRAS
AD1
(C+I+G1)
DLF1 (Private
+
Government)
AD2
(C+(I-I1)+G1)
DLF
(Private
Demand)
QLF QLF1
Quantity of Loanable Funds
AD
Y Y2 Y1
Real Gross Domestic Product
(C+I+G)
Barro-Ricardo Effect
• The Barro-Ricardo Effect is feedback caused by
a Crowding Out effect.
• Higher interest rates associated with Crowding
Out cause individuals to save more of their
incomes.
• The rise in savings increases the supply of
loanable funds, thereby reducing the real
interest rate.
• The B-R effect has a smaller impact and usually
doesn’t fully negate a crowding out effect.
Monetary Policy
• Money is Neutral: any changes of the money
supply can stabilize the economy.
• Any attempt to grow the economy will result in
inflation.
• At any moment, the money supply is fixed
• The supply of money is controlled by the Federal
Reserve (the FED), using three main
techniques.
• Discount Rate, Fed Funds Rate, & Required
Reserve Ratio.
Expansionary and
Contractionary Policy
• Expansionary Policies are used to increase the
money supply (ex. Decrease RRR, Discount or
Fed Funds Rate)
• Contractionary Policies are used to reduce the
money supply (ex. Raise RRR, Discount or Fed
Funds Rate)
• Interest rates increase and decrease in an
inverse relationship with changes in the money
supply.
The Discount Rate
• This is the interest rate that banks pay to
borrow emergency cash from the FED
• Also known as the “Overnight” rate.
• Short term loans cover checkable deposits
held by the banks and the FED.
• These are determined at the district level
but are adjusted with input from D.C.
• The FED is the lender of last resort.
Required Reserves Ratio
• Banks are required to retain some of their
deposits on hand in the form of vault cash or
on deposit at a federal reserve bank.
• The quantity of reserve is determined as a
percentage of checkable deposits.
• That percentage is called the RRR or Required
Reserve Ratio.
• 1/RRR = Simple Deposit Expansion Multiplier
• The multiplier determines the total growth of the
money supply from checkable deposits.
Fed Funds Rate
• AKA the “Immediate rate”, it is the ir that banks
charge each other to borrow money
• The supply of money relative to the demand for
it determines the ir.
• The FFR is not set at a particular %, but is
“targeted” by changing the money supply
through the purchase or sale of bonds on the
open market.
• Buying bonds from the public pumps money
into the economy, selling bonds takes money
out of the system.
The Bond Market
• Bonds are loans made to the government by
individuals and institutions with a guaranteed
rate of return and a clearly defined time limit.
• Bond Prices and ir are inversely related
• Governments (state, federal, and local) use the
sale of bonds to pay for deficit spending.
• The FED buys and sells bonds to stabilize the
economy after deficit spending.
• Bond rates send signals to both domestic and
international buyers.
Net Foreign Investment
• High Interest rates in the U.S. encourage net
foreign investment in U.S. Bonds. D for $ rises,
exports down, and imports up.
• Low Interest Rates in the U.S. discourage net
foreign investment in U.S. Bonds. D for $ falls,
exports up, and imports down.
• Increased Net Investment in U.S. Bonds is
called Capital Inflow (or “Injection”).
• Decreased Net Investment in U.S. Bonds is
called Capital Outflow (or “leakage”).