Determinants of interest rate

Borrowing and lending in the financial market depend to a significant extent on the rate of interest. In economics interest is a payment for the services of capital. It represents a return on capital.

Interest is the price of hiring capital. Capital, as a factor of production, takes the form of machinery, equipment or any other physical assets used in production of goods.

Market rate of interest

The payment to those who supply financial capital for its use is called the market rate of interest. This is expressed as a percentage of sum of funds borrowed. The interest rate is determined by demand and supply: the demand for present control of resources by those who do not have it, and the supply from those who do have control and are willing to surrender it for a price.

PURE INTEREST AND GROSS INTEREST RATES

According to Prof. Meyers, interest is the price paid for the use of loanable funds. Different rates of interest are charged for the same sum of loan for the same period because of the fact that some loans involve more risk, more inconvenience and more incidental work.

Types of interest rate

Pure interest rate Gross interest rate The pure interest is the payment for the use of money as capital when there is neither inconvenience risk nor any other management problem. Gross interest is the gross payment which the lender gets from the borrower. It includes not only net interest but also payment for other elements, which have been outlined below.

Elements of Gross interest Payment for risk : Every loan, if not secured fully, involves risk of nonpayment due to the inability or unwillingness of the borrower to pay back the debt. The lender charges something extra for taking such risk. Payment for inconvenience : The moneylender may add extra charges for the inconvenience caused to him. The greater the inconvenience involved, the higher will be such charge and consequently the gross interest. For instance, the borrower may repay at a very inconvenient time to the lender or the borrower may invest the capital for a period longer than the one for which loan has been given. Payment for management : The lender expects to be compensated for the additional work he has to do in connection with lending e.g., the form of keeping accounts, sending notices and reminders and other incidental work. Payment for exclusive use of money, i.e. pure interest: It is the payment for the use of money which is in addition to payments for the abovementioned risks, inconvenience and management.

NOMINAL INTEREST RATE VS REAL INTEREST RATE The nominal interest rate (money interest rate) is the interest rate on money in term of money. In finance and economics nominal interest rate refers to the rate of interest before adjustment for inflation (in contrast with the real interest rate.) . Changes in the nominal interest rate often move with changes in the inflation rate. The Real interest rate is corrected for inflation and is calculated as the nominal interest rate minus the rate of inflation. In the case of a loan, it is this real interest that the lender receives as income. If the lender is receiving 8 percent from a loan and inflation is 8 percent, then the real rate of interest is zero because nominal interest and inflation are equal. A lender would have no net benefit from such a loan because inflation fully diminishes the value of the loan's profit. Nominal versus real interest rate The relationship between real and nominal interest rates can be described in the equation: real interest rate = nominal interest rate - expected inflation In this analysis, the nominal rate is the stated rate, and the real interest rate is the interest after the expected losses due to inflation. Since the future inflation rate can only be estimated, the real interest rates may be different; the premium paid to actual inflation may be higher or lower. In contrast, the nominal interest rate is known in advance.

LEVEL OF INTEREST RATES Interest is the price the borrowers must pay to lenders to obtain the use of money for a period of time. As all the other prices are determined in different markets, the equilibrium rate of interest is also determined in financial markets. Given below are three theories about the determination of interest rates: The Classical Theory: This Theory states that the rate of interest is determined by real factors, namely the supply of savings and the demand for investment, the productivity of capital goods providing the elements of demand and the peoples time preference limiting the supply. The Loanable Fund Theory: This theory states that the supply of savings plus the credit creation by the financial system on the one hand, and total borrowing in the economy on the other, determine the rate of interest.

The keynesian Theory: This theory states that the rate of interest is a reward for parting with liquidity, and it is determined by the demand for and supply of money in the economy.

Theory of term structure of interest rates

Interest rates are also related to the term to maturity of a security. This relationship is often called as the term structure of interest rates or yield curve. The term structure of interest rates compares the interest rates on securities assuming that all characteristics (i.e., default risk, liquidity risk) except maturities are same.

Securities with identical default risk, liquidity, and tax characteristics may still have different interest rates because the time remaining to maturity is different. Yield curve is a plot of the yield on securities with differing terms to maturity but the same risk, liquidity and tax considerations. Shape of the yield curve: 1. Usually upward-sloping (long-term i > short-term i ) sometimes inverted (long-term i < short-term i ) 2. Flat implies short- and long-term rates are similar.

There are three theories that economists use to explain the term structure of interest rates: 1) Expectations Hypothesis 2) Segmented Markets Theory 3) The Liquidity Premium (preferred habitat) Theory. EXPECTATION THEORY Expectations theory, also termed expectations hypothesis, is one of the most common economic theories of term structure. It comes in several variations, the most widely known being the unbiased expectations theory. The unbiased expectations theory contends that the long-term rate is the geometric mean of the intervening shortterm rates. Further, it suggests that if the term structure is upward sloping, inflation rates are expected to rise in the future. A flat term structure, according to the theory, indicates little change in inflation is expected, and if the term structure is downward sloping, inflation is expected to fall over the period. Another variation is local expectations theory, which says that the expected rate of return on future maturities is actually equal to the short-term risk-free rate (e.g., current Treasury bill yield) adjusted for inflation.

MARKET SEGMENTATION THEORY

This theory is also called the segmented market hypothesis. In this theory, financial instruments of different terms are not substitutable. As a result, the supply and demand in the markets for short-term and long-term instruments is determined largely independently. Prospective investors decide in advance whether they need short-term or long-term instruments. If investors prefer their portfolio to be liquid, they will prefer short-term instruments to long-term instruments. Therefore, the market for short-term instruments will receive a higher demand. Higher demand for the instrument implies higher prices and lower yield. The interest rates are generally referred to as spot and forward rates:Forward rate refers to yield to maturity for bond which is expected to exist in future: Spot rate:- refers to the interest rate for bond, which currently exists and is being currently bought and sold. Forward rates are implicit. These rates cannot be observed, whereas, spot rates can be observed. This explains the stylized fact that short-term yields are usually lower than long-term yields. This theory explains the predominance of the normal yield curve shape. However, because the supply and demand of the two markets are independent, this theory fails to explain the observed fact that yields tend to move together (i.e., upward and downward shifts in the curve).

LIQUIDITY PREMIUM THEORY

The Liquidity Premium Theory is an outcome of the Pure Expectations Theory. The Liquidity Premium Theory asserts that long-term interest rates not only reflect investors assumptions about future interest rates but also include a premium for holding long-term bonds (investors prefer short term bonds to long term bonds), called the term premium or the liquidity premium. This premium compensates investors for the added risk of having their money tied up for a longer period, including the greater price uncertainty. Because of the term premium, long-term bond yields tend to be higher than short-term yields, and the yield curve slopes upward. Long term yields are also higher not just because of the liquidity premium, but also because of the risk premium added by the risk of default from holding a security over the long term. The liquidity preference theory, in conjunction with the unbiased expectations theory, suggests that an upward sloping term structure would be expected to occur more often than a downward sloping term structure.

Determinants of general structure of interest rates

Default risk: Risk that a security issuer will default on the security by missing an interest or principal payment. All financial assets, except governments securities are subject to some degree of default risk although they differ in their degree of risk.
Tax status: tax features cause difference on similar financial assets or claims. Marketability or liquidity: The financial assets differ in their marketability or liquidity that is they differ in respect of the possibility that a significant amount of security can be sold relatively quickly without price concessions. Inflation: The continual increase in the price level of a basket of goods and services. Special Provisions: Provisions (e.g., convertibility and callability) that impact the security holder beneficially or adversely and as such are reflected in the interest rate on security that contains such provisions.

FACTORS AFFECTING MARKET INTEREST RATES

Economic Conditions Interest rates have a tendency to move up and down with changes in the volume of business activities. In period of rapid economic growth, business firms require large amount of capital to finance increased requirements of working capital and fixed asset. The business demand for borrowed funds, combined with increase in consumer borrowing put upward pressure on interest rates. Monetary Policy The central bank of a country controls money supply in the economy through its monetary policy. In India, the RBIs monetary policy primarily aims at price stability and economic growth. If the RBI loosens the monetary policy (i.e., expands money supply or liquidity in the economy), interest rates tend to get reduced and economic growth gets stimulate; at the same time, it leads to higher inflation. On the other hand, if the RBI tightens the monetary policy, interest rates rise leading to lower economic growth; but at the same time, inflation gets curbed. So, the RBI often has to do a balancing act. The key policy rate the RBI uses to inject/remove liquidity from the monetary system is the repo rates. Changes in repo rates influence other interest rates too.

Inflation: Inflation is a rise in the general price level of goods and services in an economy over a period of time. When the price level rises, each unit of currency can buy fewer goods and services than before, implying a reduction in the purchasing power of the currency. So, people with surplus funds demand higher interest rates, as they want to protect the returns of their investment against the adverse impact of higher inflation. As a result, with rising inflation, interest rates tend to rise. The opposite happens when inflation declines. Global liquidity: If global liquidity is high, then there is a strong chance that the domestic liquidity of any country will also be high, which would put a downward pressure on interest rates.

Recession: During recession economic activities slow down. Expectation in fall in price discourage investment, reducing the demand for credit. This result in fall in interest rate. Uncertainty: If the future of economic growth is unpredictable, the lenders tend to cut down on their lending or demand higher interest rates from individuals or companies borrowing from them as compensation for the higher default risks that arise at the time of uncertainties or do both. Thus, interest rates generally tend to rise at times of uncertainty. Of course, if the borrower is the Government of India, then the lenders have little to worry, as the government of a country can hardly default on its loan taken in domestic currency.

Impact of interest rates

There are individuals, companies, banks and even governments, who have to borrow funds for various investment and consumption purposes. At the same time, there are entities that have surplus funds. They use their surplus funds to purchase bonds or Money Market instruments. Alternatively, they can deposit their surplus funds with borrowers in the form of fixed deposits/ wholesale deposits. Changes in the rate of interest can have significant impact on the way individuals or other entities behave as investors and savers. These changes in investment and saving behavior subsequently impact the economic activity in a country. For example, if interest rates rise, some individuals may stop taking home loans, while others may take smaller loans than what they would have taken otherwise, because of the rising cost of servicing the loan. This will negatively impact home prices as demand for homes will come down. Also, if interest rates rise, a company planning an expansion will have to pay higher amounts on the borrowed funds than otherwise. Thus the profitability of the company would be affected. So, when interest rates rise, companies tend to borrow less and invest less. As the demand for investment and consumption in the economy declines with rising interest, the economic growth slows down. On the other hand, a decline in interest rates encourage investment spending and consumption spending activities and the economy tends to grow faster.

MONETARY POLICY
It is concerned with the changing the supply of money stock and rate of interest for the purpose of stabilizing the economy at full employment or potential output level by Influencing the level of aggregate demand. At times of recession monetary policy involves the adoption of some monetary tools which tends to increase the money supply and lower interest rate so as to stimulate aggregate demand in the economy. At the time of inflation monetary policy seeks to contract aggregate spending by tightening the money supply or raising the rate of return.
AIMS OF MONETARY POLICY MP is a part of general economic policy of the govt. Thus MP contributes to the achievement of the goals of economic policy. Objective of MP may be: 1. Full employment 2.Stable exchange rate 3.Healthy BoP 4.Economic growth 5.Reasonable Price Stability 6.Greater equality in distribution of income & wealth 7.Financial stability

TOOLS FOR MONETERY POLICY Bank rate policy Open market operations Changing cash reserve ratio Undertaking selective credit controls

BANK RATE POLICY

Bank rate is the minimum rate at which the central bank of a country provides loan to the commercial bank of the country. . Bank rate is also called discount rate because bank provide finance to the commercial bank by rediscounting the bills of exchange. . When Central bank raises the bank rate, the commercial bank raises their lending rates, it results in less borrowings and reduces money supply in the economy.

LIMITATIONS Well organized money market should exist in the economy. It is not present in India . It is useful during the times of inflation but it does not full fill its purpose during the time of recession or depression.

OPEN MARKET OPERATIONS

It means the purchase and sale of securities by central bank of the country. It is useful for the developed countries. . The sale of security by the central bank leads to reduction of credit and purchase there of to credit expansion. LIMITATIONS When the central bank purchases the securities the cash reserve of member bank will be increased and vise versa. The bank will expand and contract credit according to prevailing economic and political circumstances and not merely with reference to their cash reserves. When the commercial bank cash balance increase the demand for loan and advance should increase. This may not happen due to economic and political uncertainty. The circulation of bank credit should have a constant velocity.

CHANGING THE CASH RESERVE RATIO The bank have to keep certain amount of bank money with them selves as reserves against deposits. The increase in the cash reserves leads to the reduction of credit only when the banks excess reserves. The decrease in the cash rate leads to the expansion of credit and banks tends to make more available to borrowers.

UNDERTAKING SELECTIVE CREDIT CONTROLS

Selective or Qualitative credit control refers to regulation of credit for specific purpose or branches of economic activity. The aim of selective controls is to discourage such forms of activity as are considered to be relatively inessential or less desirable. In India, such controls have been used to prevent speculative hoarding of commodities like food grains and essential raw material to check an under rise in their prices. Credit controls are considered to be useful supplement to general credit regulations.

Measures of money supply

The total supply of money in circulation in a given country's economy at a given time. There are several measures for the money supply, such as M1, M2, and M3.

The money supply is considered an important instrument for controlling inflation by those economist who say that growth in money supply will only lead to inflation if money demand is stable In order to control the money supply, regulators have to decide which particular measure of the money supply to target .
The broader the targeted measure, the more difficult it will be to control that particular target. However, targeting an unsuitable narrow money supply measure may lead to a situation where the total money supply in the country is not adequately controlled.

Reserve Money (M0): Currency in circulation + Bankers deposits with the RBI + Other deposits with the RBI
M1: Currency with the public + Deposit money of the public (Demand deposits with the banking system + Other deposits with the RBI).

M2: M1 + Savings deposits with Post office savings banks. M3: M1+ Time deposits with the banking system = Net bank credit to the Government + Bank credit to the commercial sector + Net foreign exchange assets of the banking sector + Governments currency liabilities to the public Net non-monetary liabilities of the banking sector (Other than Time Deposits). M4: M3 + All deposits with post office savings banks (excluding National Savings Certificates).

EXPANSIONERY MONETARY POLICY Problem: Recession and unemployment Measures: (1) Central bank buys securities through open market operation (2) It reduces cash reserves ratio (3) It lowers the bank rate Money supply increases Investment increases

Aggregate demand increases

Aggregate output increases by a multiple of the increase in investment

TIGHT MONETERY POLICY Problem: Inflation Measures: (1) Central bank sells securities through open market operation (2) It raises cash reserve ratio and statutory liquidity (3) It raises bank rate (4) It raises maximum margin against holding of stocks of goods Money supply decreases

Interest rate raises

Investment expenditure declines Aggregate demand declines Price level falls

The Demand for Money

The demand for money is affected by several factors, including the level of income, interest rates, and inflation as well as uncertainty about the future. The way in which these factors affect money demand is usually explained in terms of the three motives for demanding money: the transactions, the precautionary, and the speculative motives Transactions motive. The transactions motive for demanding money arises from the fact that most transactions involve an exchange of money. Because it is necessary to have money available for transactions, money will be demanded. The total number of transactions made in an economy tends to increase over time as income rises. Hence, as income or GDP rises, the transactions demand for money also rises. Precautionary motive. People often demand money as a precaution against an uncertain future. Unexpected expenses, such as medical or car repair bills, often require immediate payment. The need to have money available in such situations is referred to as the precautionary motive for demanding money.

Speculative motive:
Money, like other stores of value, is an asset. The demand for an asset depends on both its rate of return and its opportunity cost. Typically, money holdings provide no rate of return and often depreciate in value due to inflation. The opportunity cost of holding money is the interest rate that can be earned by lending or investing one's money holdings. The speculative motive for demanding money arises in situations where holding money is perceived to be less risky than the alternative of lending the money or investing it in some other asset. For example, if a stock market crash seemed imminent, the speculative motive for demanding money would come into play; those expecting the market to crash would sell their stocks and hold the proceeds as money. The presence of a speculative motive for demanding money is also affected by expectations of future interest rates and inflation. If interest rates are expected to rise, the opportunity cost of holding money will become greater, which in turn diminishes the speculative motive for demanding money. Similarly, expectations of higher inflation presage a greater depreciation in the purchasing power of money and therefore lessen the speculative motive for demanding money.

Money supply

Money is something that is used as a medium of exchange, a store of value and a unit of account.

In its narrow most definition (M0) money comprises of all currency in circulation. M1 is all currency plus demand deposits. Adding post office deposits to M1 we get M2. M3 consists of currency plus demand deposits plus time deposits. Adding post office deposits to M3 we get M4.

The Supply and Demand of Money

People hold money: To conduct transactions For precautionary reasons, such as to meet emergencies, such as unexpected medical bills As a store of value Holding money has an opportunity cost in the sense that the money could be invested elsewhere and earn interest. Even if the money is held in an interest-earning checking account, a higher rate of interest could be earned by purchasing financial instruments such as bonds. As the rate of interest goes higher, the opportunity cost of money increases. So as interest rates go up (down), people will be less (more) willing to hold money. The supply of money is usually determined by the Central Bank and the targeted supply of money is not directly related to the interest rate. A graph for the supply and demand for money, as a function of the interest rate, would appear similar to figure 1 on the next slide..

Figure 1 The Supply and Demand for Money

Note that this demand curve assumes other relevant factors are held constant. If the quantity of goods produced increases and/or the price level increases, the demand for money will increase. This causes the demand curve to shift to the right. If economic activity declines and/or prices go down, then demand for money will decrease. Changes in the availability of financial instruments are also changing the demand for money over time. The widespread availability of credit cards has reduced the amount of money that households need to keep on hand.

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