INTEREST RATE :

An interest rate is the rate at which interest is paid by a borrower for the use of money
that they borrow from a lender. For example, a small company borrows capital from a
bank to buy new assets for their business, and in return the lender receives interest at a
predetermined interest rate for deferring the use of funds and instead lending it to the
borrower. Interests rates are fundamental to a capitalist society Interest rates are normally
expressed as a percentage rate over the period of one year

Interest rates targets are also a vital tool of monetary policy and are taken into account
when dealing with variables like investment, inflation, and unemployment…..

 The economy can be influenced easily by interest rates. When interest rates are high,
people do not want to take loans out from the bank because it is more difficult to pay the
loans back, and the number of purchases of cars and homes goes down. The opposite is
also true.
 The effects of a lower interest rate on the economy are very beneficial for the
consumer. When interest rates are low, people are more likely to take loans out of the
bank in order to pay for things like houses and cars. When the market for those things
gets strong, price decreases and more people can purchases these things. This also bodes
well for investors, who perceive less risk in taking out a loan and investing it in
something because they would have to pay less back to the bank.

 When people do not have to spend as much money on bank payments, they have
more disposable income to put toward things they want to purchase. Suddenly, a trip to
the ice cream store is not so much of a budget crunch and a weekend at the spa seems
more doable. These effects, although certainly not direct, are enough to stimulate the
market when interest rates are low.
 Low interest rates are not beneficial for lenders, who are seeing less of a return on
their loan than in times when interest rates are high. This means that banks may find
themselves having to lower the interest rates accrued on money deposited in the bank in
order to maintain a steady profit. However, interest rates do not really have an effect on
how much people save, because an increased amount of disposable income means that
they are more likely to spend it than to save it.

 When interest rates increase, though, foreign investment can increase because people
outside of the country want a larger return for their investment and they are more likely to
get it in a state of high interest rates. This causes more demand for the dollar, driving up
its value in the international market. The opposite happens, though, when the interest
rates are decreased.
 Although much of it is contained within consumers' perception of the economy and
their income, interest rates can drive up consumer spending, investment and the amount
of loans people take out of the bank. Or they can increase foreign investment

Reasons for interest rate change

• Political short-term gain: Lowering interest rates can give the economy a short-
run boost. Under normal conditions, most economists think a cut in interest rates
will only give a short term gain in economic activity that will soon be offset by
inflation. The quick boost can influence elections. Most economists advocate
independent central banks to limit the influence of politics on interest rates.

• Deferred consumption: When money is loaned the lender delays spending the
money on consumption goods. Since according to time preference theory people
prefer goods now to goods later, in a free market there will be a positive interest
rate.

• Inflationary expectations: Most economies generally exhibit inflation, meaning

a given amount of money buys fewer goods in the future than it will now. The
borrower needs to compensate the lender for this.

• Alternative investments: The lender has a choice between using his money in
different investments. If he chooses one, he forgoes the returns from all the others.
Different investments effectively compete for funds.

• Risks of investment: There is always a risk that the borrower will go bankrupt,
abscond, or otherwise default on the loan. This means that a lender generally
charges a risk premium to ensure that, across his investments, he is compensated
for those that fail.
 • Liquidity preference: People prefer to have their resources available in a form
that can immediately be exchanged, rather than a form that takes time or money to
realise.

• Taxes: Because some of the gains from interest may be subject to taxes, the
lender may insist on a higher rate to make up for this loss..

Open Market Operations in the United States

The effective federal funds rate in the US charted over more than half a century

The Federal Reserve (often referred to as 'The Fed') implements monetary policy largely
by targeting the federal funds rate. This is the rate that banks charge each other for
overnight loans of federal funds, which are the reserves held by banks at the Fed. Open
market operations are one tool within monetary policy implemented by the Federal
Reserve to steer short-term interest rates. Using the power to buy and sell treasury
securities

EFFECTS OF INTEREST RATE ON THE ECONOMY

The Interest Rate (IR) is considered as one of the most important economic factors
affecting every household, firm and government all over the world. It is, as described by
Parkin et al (2005), the opportunity cost of holding money, that is, the price of borrower
are willing to pay for the use of the loan. On the other hand, it is also the compensation to
the risk that lenders take in lending the money. (investopedia.com, n.a. 2003) By lenders
and borrowers, it refers to individuals, businesses, financial instruments and
governments. IR can be also categorized into nominal IR that is the stated one on
financial market and real IR that implies the return of investment in terms of value. IR is
said to be an indicator of economy situation and reflection of government policy as well.
Therefore fluctuations of IR would have great impact on different areas in the economy
and it is crucial to understand what determines it and how it would affect the world.

This paper presents a general analysis of models of determinations s of interest rate,

which are relevant to the UK economy. Thereafter, the effects of changes in IR to the
economy growth will be examined. Then a conclusion will be drawn to generate the key
points the paper has mentioned.

Out of all, state of economy is the fundamental parameters of IR. (Toews, 2006) when an
economy experiences a growth period, IR is decreased to stimulate the amount of money
circulating in the market. Conversely, IR is relatively high when a stagnation or recession
occurs.

Figure 1 illustrates the relationship between real GDP which represents the economic
grow and IR over 40 years in the UK. In the late 1980s the UK experiencing a huge
stagnation period and from the figure the IR was high and the gap between IR and real
GDP. During the late 1990s the UK economy were growing and the IR dropped. The
observations reveal that a high growth will lead to low interest rate and vise versa
WORLD INTEREST RATE TABLE

MAJOR CENTRAL BANKS OVERVIEW

CENTRAL BANK NEXT MEETING LAST CHANGE CURRENT

INTEREST RATE
Bank of Canada Dec 7. 2010 Sep 08 2010 1%
Bank of England Nov 04 .2010 Mar 05 2009 0.5 %
European Central Nov 04 . 2010 May 07. 2009 1%
Bank
Federal Reserve Nov 03 .2010 Dec 16. 2008 0.25 %
Swiss National Dec16 2010 Mar 12 2009 0.25 %
Bank
The Reserve Bank Nov 02 .2010 May 04. 2010 4.5 %
of Australia
Bank of Japan N/A Dec 19 2008 0.1 %

Country Current Interest Previous Last Change

Rate
China 5.56 % 5.31 % Oct 19 2010
Republic of Korea 2.25 % 2.00% July 09 2010
Norway 1.75 % 1.50 % Dec 16 2009
Sweden 1.00 % 0.75 % Oct 26 2010
Brazil 10.75 % 10.25 % July 21 2010

Why interest rates change

When interest rates change, it is the result of many complex
factors. People who study interest rates find that it is as
difficult to forecast future interest rates as it is the
weather. Since interest rates reflect human activity, a
long-term forecast is virtually impossible. After the
 fact, explanations are many and confident! Some of the
major factors which help to dictate interest rates are
explained below.

Supply and Demand for Funds

Interest rates are the price for borrowing money. Interest rates move up and down,
reflecting many factors. The most important among these is the supply of funds, available
for loans from lenders, and the demand, from borrowers. For example, take the mortgage
market. In a period when many people are borrowing money to buy houses, banks and
trust companies need to have the funds available to lend. They can get these from their
own depositers. The banks pay 6% interest on five year GICs and charge 8% interest on a
five year mortgage. If the demand for borrowing is higher than the funds they have
available, they can raise their rates or borrow money from other people by issuing bonds
to institutions in the "wholesale market". The trouble is, this source of funds is more
expensive. Therefore interest rates go up! If the banks and trust companies have lots of
money to lend and the housing market is slow, any borrower financing a house will get
"special rate discounts" and the lenders will be very competitive, keeping rates low.

This happens in the fixed income markets as a whole. In a booming economy, many
firms need to borrow funds to expand their plants, finance inventories, and even acquire
other firms. Consumers might be buying cars and houses. These keep the "demand for
capital" at a high level, and interest rates higher than they otherwise might be.
Governments also borrow if they spend more money than they raise in taxes to finance
their programs through "deficit financing". How governments spend their money and
finance is called "fiscal policy". A high level of government expenditure and borrowing
makes it hard for companies and individuals to borrow, this is called the "crowding out"
effect.

Monetary Policy

Another major factor in interest rate changes is the "monetary policy" of governments. If
a government "loosens monetary policy", this means that it has "printed more money".
Simply put, the Central Bank creates more money by printing it. This makes interest rates
lower, because more money is available to lenders and borrowers alike. If the supply of
money is lowered, this "tightens" monetary policy and causes interest rates to rise.
Governments alter the "money supply" to try and manage the economy. The trouble is, no
one is quite sure how much money is necessary and how it is actually used once it is
available. This causes economists endless debate.

Inflation

Another very important factor is inflation. Investors want to preserve the "purchasing
power" of their money. If inflation is high and risks going higher, investors will need a
higher interest rate to consider lending their money for more than the shortest term. After
the very high inflation years of the 1970s and early 1980s, lenders had to receive a very
high interest rate compared to inflation to lend their money. As inflation dropped,
investors then demanded lower rates as their expectations become lower. Imagine the
plight of the long-term bond investor in the high inflation period. After lending money at
5-6%, inflation moved from the 2-3% range to above 12%! The investor was receiving
7% less than inflation, effectively reducing the investor's wealth in real terms by 7% each
year!

PAKISTAN ‘S LATEST INTEREST RATE

Announcing the bi-monthly Monetary Policy Review, the central bank said the decision
to increase the interest rate to 13.5 per cent was taken at a meeting of the central board of
directors of the State Bank held under the chairmanship of Governor Shahid Hafeez
Kardar. This is Kardar’s first policy announcement since he assumed office earlier this
month.

The interest rate rise, which will be effective from September 30, caught analysts off
guard, many of whom were expecting the central bank to leave the rate unchanged.

“The monetary policy stance is formed by the consideration that the impact of continued
inflation is substantial and felt by the entire economy,” the SBP said. It said the private
sector is bearing the brunt of the interest rate hike because of the difficulty in containing
the fiscal deficit.

In 2009-10, the fiscal deficit was 6.3 per cent of gross domestic product, substantially
higher than the target of 5.1 per cent. This year too, the gap is expected to be above 6 per
cent.

The bank hinted that further increases in the policy rate may be on the cards. “The next
quarter will be crucial in forming an assessment of the effectiveness of government
efforts to contain fiscal deficit and its inflationary borrowings from the SBP and the
banking system.”
The policy decision manuscript explained that food inflation in recent months spiked
beyond historic levels due to the floods. “It may take two or three months for food
inflation to return to normal levels,” it added.

In its previous policy review at end-July, the central bank had increased the policy rate by
50 basis points to 13 per cent, after an earlier easing was interrupted by spiraling
inflation. Although analysts had been expecting stagnation in the policy rate for now, the
SBP cited that “in the aftermath of the floods, bringing inflation down to single digit will
require a supportive and sustained financial and fiscal effort over the next couple of
years.”

The bank also said that “to finance the budget deficit the government has increased its
reliance on the SBP,” adding there was no commensurate increase in tax revenues for the
government to balance its rising expenditures.

The bank warned that the federal government’s over-reliance on borrowings from the
central bank could mean further monetary tightening in coming months, which will likely
raise tempers of an already burdened private sector.

Inflation & Interest Rates

Price Inflation greatly effects time value of money (TVM). It is a major component of
interest rates which are at the heart of all TVM calculations. Actual or anticipated
changes in the inflation rate cause corresponding changes in interest rates. Lenders know
that inflation will erode the value of their money over the term of the loan so they
increase the interest rate to compensate for that loss. Figure 2 showed that inflation has
been nearly continuous in the U.S. since shortly after World War II. As you can see,
long-term loans made at the real rate of interest without an inflation premium would have
actually produced negative returns due to the declining purchasing power of the dollar.

An estimate of the inflation premium contained in interest rates can be seen by comparing
two risk-free securities with the same maturity date, one with a fixed rate and the other
with a rate indexed for inflation. The Fed strongly influences short term interest rates
with their monetary policy. However, longer term rates are set by the market and reflect
an inflation rate which is its current best guess.

Although it may not be a perfect indicator, the yield of a 10 year, fixed-rate U.S.Treasury
note when compared with the rate of a Treasury Inflation Protected Security (TIPS) of the
same maturity at least shows that some amount of inflation premium certainly does exist.
For example, the Fed Funds rate was recently at 1% and the year-to-year percent change
in the CPI (current inflation rate) was 2.3%. At the same time, the anual yield of the
fixed-rate note was 4.75% while the TIPS note was at 2%. This would indicate that the
market currently expects an average annual inflation rate of around 2.75% (4.75% - 2%)
over the ten year period and have added that inflation premium to the fixed-rate, non
inflation protected note.

Lower Interest Rates

Ten ways to benefit from low interest rates
1. Pay off any debt you can that is not your mortgage

The golden rule, when you have any spare cash, is always to pay down the most
expensive debt first. So if you have credit card debt that is not on a 0pc interest deal, or
you have an expensive loan, this should be the first place to put your spare money, if you
can.

2. Overpay your mortgage

It may seem a boring way to use your extra cash, but overpaying your mortgage with the
extra money you are receiving could yield very significant savings in the long term, as
well as possibly allowing you to get better mortgage deals in future.

3. Start a regular savings account

Although interest rates have fallen, some of the best remaining savings rates are reserved
for those who are willing to put money away regularly. Even more attractively, some
banks are offering fixed rates on their regular savings, meaning that your money will not
suffer from falling interest rates.

4. Drip feed it into investments

The stock market has taken a pounding over recent months, and whether you want to dip
a toe into its choppy waters depends on your own feelings about its fragility. However,
experts continually advise that the best way to take advantage of a market downturn is to
regularly put money into a fund or into stocks that you like – rather than trying to guess
the bottom of the market.

5. Take out payment protection insurance

If you fear that if you lose your job you could also lose your home, your mortgage
windfall could buy you some peace of mind.

Payment protection insurance (PPI), traditionally sold with loans and credit cards, has not
always been a popular product, with fines for mis-selling rife. However, it is possible to
insure your income for up to 12 months in the event of redundancy using a stand-alone
product.
6. Save for your children's future

Thanks to Gordon Brown, every child born since 2002 has their very own trust fund,
started off with a £250 voucher from the Government. The vast majority of these are
stakeholder funds, which are invested in equities.

Your child's account may have had a torrid time over the past few months, but the
principle of regular savings adding up over the long term still applies. Over nearly all 18-
year periods in history, investing in equities has outperformed money in a deposit
account, and since your child cannot access this money until they are 18 there is plenty of
time to take a long-term view.

7 . Take Account of Pension

Savers looking further into the future might want to use the windfall to add to their
pension contributions – another way to get their money away from the taxman.

Saving £120 a month into a pension is unlikely to produce life-changing amounts of

money for a 55-year-old starting to save now (although it will make a difference), but for
a 35-year-old the difference could be more impressive. According to Legal & General's
stakeholder pension calculators, a 35-year-old man putting £120 a month into a pension
could end up with an income of £212 a month in retirement at 65

8. Buy a health cashplan

Health cashplans are different from more expensive health insurance – but they could be
a good buy if you regularly pay to have your eyes tested and to go to the dentist. They
will also provide backup for other more expensive procedures.

With a cashplan, you arrange for the treatment yourself and pay the money. Then you
send the plan provider a claim form and your receipt and it will pay you back some or all
of the cost for that treatment.

9. Prepay your children's school fees

If you are planning to pay for private education for a child or grandchild, it pays to start
early. You could put your extra money into a savings plan to help with costs in the future.

If your child is already in a private school, many will let you pay the fees in advance,
which could also insulate you against later rises in fees

10. Spend the lot to stimulate the economy

Here's Gordon Brown's preferred option. That £120 a month extra could give the
economy a much-needed fillip if you went out and spent it on Britain's high streets. A
couple of lattes and an expensive meal out suddenly seem like the charitable thing to do.
And it might make you feel better in the short term. On the other hand, the options above
are likely to benefit your family better if times really get tough. And you can't save the
economy single-handed, you know..

IMPACTS OF HIGHER INTEREST RATES

Higher interest rates have various economic effects:

1. Increases the cost of borrowing. Interest payments on credit cards and loans are
more expensive. Therefore this discourages people from borrowing and saving.
People who already have loans will have less disposable income because they
spend more on interest payments. Therefore other areas of consumption will fall.
2. Increase in mortgage interest payments. Related to the first point is the fact that
interest payments on variable mortgages will increase. This will have a big impact
on consumer spending. This is because a 0. 5% increase in interest rates can
increase the cost of a £100,000 mortgage by £60 per month. This is a significant
impact on personal disposable income.
3. Increased incentive to save rather than spend. Higher interest rates make it
more attractive to save in a deposit account because of the interest gained.
4. Higher interest rates increase the value of £ (due to hot money flows. Investors
are more likely to save in British banks if UK rates are higher than other
countries) A stronger Pound makes UK exports less competitive - reducing
exports and increasing imports. This has the effect of reducing Aggregate demand
in the economy.
5. Rising interest rates affect both consumers and firms. Therefore the economy
is likely to experience falls in consumption and investment.
6. Government debt interest payments increase. The UK currently pays over
£23bn a year on its own national debt. Higher interest rates increase the cost of
government interest payments. This could lead to higher taxes in the future.
7. Reduced Confidence. Interest rates have an effect on consumer and business
confidence. A rise in interest rates discourages investment; it makes firms and
consumers less willing to take out risky investments and purchases.

Evaluation

• It effects people in different ways. The effect of higher interest rates does not
affect each consumer equally. Those consumers with large mortgages (often first
time buyers in the 20s and 30s) will be disproportionately affected by rising
interest rates. For example, reducing inflation may require interest rates to rise to
 a level that cause real hardship to those with large mortgages. This makes
monetary policy less effective as a macro economic tool.
• Time lags. The effect of rising interest rates can often take up to 18 months to
have an effect. For exampl,e if you have an investment project 50% completed,
you are likely to finish it off. However, the higher interest rates may discourage
starting a new project in the next year.
• It depends upon other variables in the economy. At times, a rise in interest
rates may have less impact on reducing the growth of consumer spending. For
example, if house prices continue to rise very quickly, people may feel that there
is a real incentive to keep spending despite the rise in interest rates.
• Real Interest Rate. It is worth bearing in mind that what is important is the real
interest rate. The real interest rate is nominal interest rates minus inflation. Thus if
interest rates rose from 5% to 6% but inflation rose from 2% to 5.5 %. This
actually represents a cut in real interest rates from 3% (5-2) to 0.5% (6-5.5) Thus
in this circumstance the rise in nominal interest rates actually represents
expansionary monetary policy..

Industry
Main article: Industry of Pakistan

Manufacturing by Province

Pakistan's two leading companies, as per Forbes Global 2000 ranking for 2005.
Template:Inote

Global
Company Name
ranking

1,284 Oil & Gas Development

1,316 PTCL
 Forbes Global 2010

Pakistan ranks forty-first in the world and fifty-fifth worldwide in factory output.

Pakistan's industrial sector accounts for about 24% of GDP. Cotton textile production and
apparel manufacturing are Pakistan's largest industries, accounting for about 66% of the
merchandise exports and almost 40% of the employed labour force. Other major
industries include cement, fertilizer, edible oil, sugar, steel, tobacco, chemicals,
machinery, and food processing.

The government is privatizing large-scale parastatal units, and the public sector accounts
for a shrinking proportion of industrial output, while growth in overall industrial output
(including the private sector) has accelerated. Government policies aim to diversify the
country's industrial base and bolster export industries.

• Industries: textiles (8.5% of the GDP), fertilizer, cement, oil refineries, dairy
products,food processing, beverages, construction materials, clothing, paper
products, shrimp
• Industrial production growth rate: 6% (2005)
• Large-scale manufacturing growth rate: 19.9% (2005)

Automobile industry

Pakistan is an emerging market for automobiles and automotive parts offers immense
business and investment opportunities. The total contribution of Auto industry to GDP in
2007 is 2.8% which is likely to increase up to 5.6% in the next 5 years. Auto sector
presently, contributes 16% to the manufacturing sector which also is expected to increase
25% in the next 7 years. Car ownership in Pakistan has risen by 40% per annum since
2001.

CNG industry

As of 2009, Pakistan is one of the largest users of CNG (compressed natural gas) in the
world. Presently, more than 2,900 CNG stations are operating in the country in 85 cities
and towns, and 1000 more would be set up in the next three years. It has provided
employment to over 50,000 people in Pakistan.

Cement industry

In 1947, Pakistan had inherited four cement plants with a total capacity of 0.5 million
tons. Some expansion took place in 1956–66 but could not keep pace with the economic
development and the country had to resort to imports of cement in 1976-77 and continued
to do so till 1994-95. The cement sector comprising of 27 plants is contributing above Rs
30 billion to the national exchequer in the form of taxes.
IT industry

Pakistan’s IT industry has been rising steadily since the last three years. A marked
increase in software export figures are an indication of this booming industry’s potential.
The total number of IT companies increased to 1306 and the total estimated size of IT
industry is $2.8 billion. In 2007, Pakistan was for the first time featured in the Global
Services Location Index by A.T. Kearney and was rated as the 30th best location for
offshoring By 2009, Pakistan had improved its rank by ten places to reach 20th.
Furthermore, Pakistan has 19 million internet users and 2.3 million facebook users.

Textiles

The Textile Industry is dominated by Punjab. 3% of United States imports regarding

clothing and other form of textiles is covered by Pakistan. Textile exports in 1999 were
$5.2 billion and rose to become $10.5 billion by 2007. Textile exports managed to
increase at a very decent growth of 16% in 2006. In the period July 2007 – June 2008,
textile exports were US$10.62 billion. Textile exports share in total export of Pakistan
has declined from 67% in 1997 to 55% in 2008, as exports of other textile sectors grew.

Mining

Pakistan is endowed with significant mineral resources and emerging as a very promising
area for prospecting/exploration of mineral deposits. Bases on available information, the
country's more than 6,00,000 km² of outcrops area demonstrates varied geological
potential for metallic and non-metallic mineral deposits. Except oil, gas and nuclear
minerals regulated at federal level, Minerals are a provincial subject, under the
constitution of Islamic Republic of Pakistan. Provincial governments are responsible for
development and exploitation of minerals, besides, enforcing regulatory regime. In line
with the constitutional framework the federal and provincial governments have jointly set
out Pakistan first National Mineral Policy in 1995, duly implemented by the provinces,
providing appropriate institutional and regulatory framework and equitable and
internationally competitive fiscal regime.

In the recent past, exploration by government agencies as well as by multinational mining

companies presents ample evidence of the occurrences of sizeable minerals deposits.
Recent discoveries of a thick oxidized zone underlain by sulphide zones in the shield area
of the Punjab province, covered by thick alluvial cover have opened new vistas for
metallic minerals exploration. Pakistan has large base for industrial minerals. The
discovery of coal deposits having over 175 billion tones of reserves at Thar in the Sindh
province has given an impetus to develop it as an alternate source of energy. There is vast
potential for precious and dimension stones.

The enforcement of Mineral Policy (1995) has paved way to expand mining sector
activities and attract international investment in this sector. International mining
companies have responded favorably to the NMP and presently at least four are engaged
in mineral projects development.
Currently about 52 minerals are under exploitation although on small scale. The major
production is of coal, rock salt and other industrial and construction minerals. The current
contribution of mineral sector to the GDB is about 0.5% and likely to increase
considerably on the development and commercial exploitation of Saindak & Reco Diq
copper and gold deposits (world largest gold mine), Duddar zinc lead, Thar coal and
gemstone deposits.

Effects of interest rate on the investors/industrialist of

Pakistan
A lower interest has a positive impact on the industrial development b/c the Investor
gets loan from the banks at a lower rate & invests in different industries.

Inversely a higher interest rate discourages investors from taking loan b/c they have
to pay higher rate when they return the loan..

A low interest rate is suitable for the industrial development.

How can a central bank control Interest Rate

Essentially, the term “interest rates” stands for a monetary compensation, usually
expressed in a percentage per annum. The lender of the fiscal amount is compensated for
the loss that he or she suffers – the owner of the money may invest them and thus
generate income instead of lending funds to the borrower.

One of the ways a central bank (or a reserve bank or other monetary authority) may
control interest rates is by open market operations. A central bank may indirectly
intervene in the economy of its country or union of states by buying government
securities. By purchases, the bank raises the price of the securities on the open market,
thus lowering their rates and the interest rates in general.

The interest rates may be modified directly by the respective monetary institution, as
well. After all, interest rates are just tools of monetary policy and may be used to curb
variables like investment and inflation. Historically speaking, interest rates have been
governed by national governments or central banks. The Fed’s federal funds rate in the
US has fluctuated from 0.25% to 19% for the period between 1954 and 2008. Variations
in the base rate of the Bank of England from 1989 to 2009 measured from lowest 0.5% to
a high of 15%. But for the layman’s mind, it is noteworthy to point out that the generally
referred to (in media) as interest rate is the annualized rate offered by a respective central
bank on overnight deposits.
As a matter of fact, there are some authors such as Daniel L. Thornton, from Federal
Reserve Bank of St. Louis, who argue that “it is money that matters and interest rates
does not”, due to the perceived virtuality of the interbank interest rates. Further Thornton
points out that monetary policy is at present conducted by targeting short-term interest
rates. The banking authorities undertake to manage the price level by manipulating
aggregate demand while fixing their targeted interest rate. So, the aforementioned author
claims that money’s role is at best tertiary. Even more, the author points out that
according to some other renowned economists, money is probably irrelevant in the
determination of the price level. But the author of the working paper argues against these
macroeconomists, claiming that the most prominent feature of money is its ability to
warrant “final payment”. He also suggests that the central banks’ ability to control
interest rates may be overtly exaggerated.

The author reports that according to Friedman (1999) “a widely shared opinion today is
that central banks need not actually do anything. With a clear enough statement of
intentions, ‘the markets will do all of the work for them’ as far as controlling the funds
rates in view of the target for the funds rate is concerned (funds rate = the interest rate at
which a depository institution lends available funds straightforward to another depository
for the overnight). The author further clarifies the EH (expectations hypothesis), stating
that “a longer-term rate is equal to the average of the current and expected future short-
term rate”. Then, he concludes that this hypothesis would mean, if true, that all rates
would be linked with the overnight rate; but the aforementioned hypothesis has been
proven wrong numerous times by authors such as Campbell and Shiller, Cochrane and
Piazzesi, and Thornton himself. The apparent erroneousness of the EH proposition gives
ground to deeply doubt FED's means of controlling the interest rates by applying the
apparatus of the expectations hypothesis.

CONCLUSION
SOURCES