A Citizens Guide to Interest Rates What most

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 • • • 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 Nominal ir – Inflation Rate = Real ir • (Calculate) • 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 Nomin al ir MS MS 1 ir ir 1 MD QM QM 1 Quantity of Money

Money Market Linked to Demand for Capital Investment Nominal Expansionary Policy MS MS 1 Investment Demand Nominal ir ir 1 MD QM QM 1 Quantity of Money I I I 1 Quantity of Capital Investment

Investment Linked to AD/AS Investment in Capital Expansionary Policy Price level Nom -inal SRAS ir PL 1 ir PL ir 1 AD 1 (C+I 1+G) I I I 1 Quantity of Capital Investment 0 AD (C+I+G) Y Y 1 Real Gross Domestic Product

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 Real ir Loanable Funds Market SLF r DLF 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: M 1: Cash, Currency, Checkable Deposits, NOW accounts, etc… M 2: Savings (under $100, 000), Short time deposits, CD’s, MMF’s, etc… M 3: 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 (M 2 is Inelastic). • The transaction demand (M 1) 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 AD 1 when G increases Then shifts back to AD 2 as I falls due to the increase in interest rates. Level r 1 SRAS Pl 1 Pl 2 r PL AD 1 (C+I+G 1) DLF 1 (Private + Government) AD 2 I 1)+G 1) DLF (Private Demand) QLF 1 Quantity of Loanable Funds AD Y Y 2 Y 1 Real Gross Domestic Product (C+I+G) (C+

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”).