Determinants of interest rate

Interest rate is the price demanded by the lender from the borrower for the use of borrowed money. In other words, interest is a fee paid by the borrower to the lender on borrowed cash as a compensation for forgoing the opportunity of earning income from other investments that could have been made with the loaned cash. Thus, from the lenders perspective, interest can be thought of as an "opportunity cost or "rent of money" and interest rate as the rate at which interest (or opportunity cost) accumulates over a period of time. The longer the period for which money is borrowed, the larger is the interest (or the opportunity cost). The amount lent is called the principal. Interest rate is typically expressed as percentage of the principal and in annualized terms. From a borrowers perspective, interest rate is the cost of capital. In other words, it is the cost that a borrower has to incur to have access to funds.

Interest rate

NOMINAL INTEREST RATE VS REAL INTEREST RATE

Nominal interest rates refer to the rate of interest prior to taking inflation into account. Depending on its application, an inflation and risk premium must be added to the real interest rate in order to obtain the nominal 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, so 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.

FACTORS AFFECTING LEVEL OF INTEREST RATES Interest rates are typically determined by the supply of and demand for money in the economy. If at any given interest rate, the demand for funds is higher than supply of funds, interest rates tend to rise and vice versa. Theoretically speaking, this continues to happen as interest rates move freely until equilibrium is reached in terms of a match between demand for and supply of funds. In practice, however, interest rates do not move freely. The monetary authorities in the country (that is the central bank of the country) tend to influence interest rates by increasing or reducing the liquidity in the system. Broadly the following factors affect the interest rates in an economy: 1. Monetary Policy 2. Growth in the economy 3. Inflation 4. Global liquidity 5. Uncertainty

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 stimulated; 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 (or reduce) liquidity from the monetary system is the repo rates (or reverse repo rates). Changes in repo rates influence other interest rates in the economy too.

Growth in the economy If the economic growth of an economy picks up momentum, then the demand for money tends to go up, putting upward pressure on interest rates. 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. 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.

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.

Theory of term structure of interest rates

There are three theories that economists use to explain the term structure of interest rates: Expectations Hypothesis Segmented Markets Theory

1) 2)

3)

The Liquidity Premium (preferred habitat)

Theory.

The 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 and it is based on the following assumptions: There is perfect competition in the financial markets. The investors are rational, i.e., they wish to maximise the yield of their holding period. Investors have perfect foresight, and a large enough body of investors hold uniform expectations about the future level and changes of short term interest rates & security prices. There are no transaction costs. Securities of different maturities are perfect substitutes for each other, i.e., they are homogeneous.

With the help of these assumptions, it is posited that todays long term rate is the geometric mean of the current short-term rates and the successive forward or expected one-period shortterm rates during the long term period . It means slope of yield curve tells us direction of expected future ST rates So

if expect ST rates to RISE, then average of ST rates will be > current ST rate

It means LT rates > ST rates so yield curve SLOPES UP

ST rates expected to rise

yield

maturity

if expect ST rates to FALL, then average of ST rates will be < current ST rate

It means LT rates < ST rates so yield curve slopes DOWN

ST rates expected to fall

yield

maturity

if expect ST rates to STAY THE SAME, then average of ST rates will be = current ST rate

It means LT rates = ST rates so yield curve is FLAT

ST rates expected to stay the same

yield

maturity

ST rates expected to rise, then fall

yield

maturity

Drawbacks

First, it totally lack realism. Its assumptions are very restrictive and unrealistic. Like Securities of different maturities are perfect substitutes but this is not likely long term securities have greater price volatility short term securities have reinvestment risk Second, while this theory explains the long term rate, it does not explain how short term rates themselves are determined and how expectation about short term rates are formed. This theory does not say anything about what can be the shape of yield curve theoretically. It merely helps to interpret the meaning of various yield curves.

MARKET SEGMENTATION THEORY

Assumption; o This theory assumes that investors are risk minimisers or risk averters. o This theory holds that securities in different maturity ranges, are imperfect substitutes of each other.

MARKET SEGMENTATION THEORY

This theory is also called the segmented market hypothesis. According to this theoryInvestors and borrowers choose securities with maturity that satisfy their forecasted cash needs. If a lender knows exactly how long his money will be available for investment, he can select the maturity date of the claim in such a way that he runs neither the income risk nor the capital risk. The coincidence of maturity date of the claim with the date of his need for cash insures him against both the risk.

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 longterm instruments is determined independently. Prospective investors decide in advance whether they need short-term or long-term instruments.

If investors and borrowers participate only in the maturity market that satisfies their particular needs , market are segmented. All this results into a number of segments in which demand for and supply of funds of each given maturity determines the interest rate.

If on demand side, demand for long term capital were predominate and on the supply side, the offer of short term money, the long term rate would come to lie above the short rates and vice versa in opposite case. Thus this theory stresses the maturity structure of debt as an important factor determining the term structure of interest rates.

Drawback

Although the market segmentation theory has added an important dimension to the explanation of interest rate structure, it is difficult to accept that lenders and borrowers are dominated only by the desire to avoid risk. In reality they care for the returns also.

LIQUIDITY PREMIUM THEORY

Assumption: o Securities of different maturities are imperfect substitutes, o investors are risk return traders o and investors PREFER ST securities Two important characteristics of investment are return & Risk, The choice of security depends upon the risk-return preferences of the investors. The expectation theory ignores risk and assumes that investors want to maximise the return. The segmentation theory assume that investor de-emphasise return and try to minimise risk. The LPT assumes that investors are risk-return traders; they do not want to maximise return whatever the risk. Similarly, they do not want to minimise risk even if entails a very low return.

This theory also holds that long-term securities are more risky than short term securities. While the variance of return on capital value is greater for long securities than short term security, the variance of return of interest income is greater in short term securities than long term ones. If it is assumed that stability of capital is valued more highly than stability of income, than long term securities have a net risk disadvantage. Investor will accept this additional risk only if long term securities are priced in such a way to offer higher yield.

Because of the higher risk in long term securities, other things being equal investor prefer to lend short. On the other hand borrower prefer to borrow long to reduce the risk of inability to meet principal repayment. Due to psychological disinclination to hold long term securities , a positive liquidity or risk premium must be offered to induce investor to purchase long term securities. Thus this theory implies the existence of the upward sloping yield curve.

The liquidity premium theory highlights the preference for liquidity and desire to minimize the sum of income risk and capital risk as the additional factor determining the term structure of rates. So according to this theory term if long term securities have a liquidity premium, then usually LT yields > ST yields or yield curve slopes up.

yield

yield curve

small liquidity premium

maturity

if ST rates are expected to rise Then liquidity premium is small

yield

yield curve large liquidity premium

maturity

if ST rates are expected to stay the same Then liquidity premium is larger,

yield

yield curve

Vary large liquidity premium

maturity

if ST rates are expected to fall then liquidity premium is vary large

Drawbacks

It is doubtful whether the investor are really more averse to capital risk than income risk. How do we interpret yield curve?
slope due to 2 things: (1) exp. about future ST rates (2) size of liquidity premium

Difficult to quantify liquidity premium By assuming risk (liquidity) premium will be mostly positive, the theory implies that the price or interest rates will be mostly increasing. This is questionable.

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.

Monetary policy

Monetary policy is the process by which monetary authority of a country, generally a central bank controls the supply of money in the economy by exercising its control over interest rates in order to maintain price stability and achieve high economic growth. In India, the central monetary authority is the Reserve Bank of India (RBI).

Instruments or technique of credit control / monetary policy

Open Market Operations The open market operation refers to the purchase and/or sale of short term and long term securities by the RBI in the open market. This is very effective and popular instrument of the monetary policy. The OMO is used to wipe out shortage of money in the money market, to influence the term and structure of the interest rate and to stabilize the market for government securities, etc. It is important to understand the working of the OMO. If the RBI sells securities in an open market, commercial banks and private individuals buy it. This reduces the existing money supply as money gets transferred from commercial banks to the RBI. Contrary to this when the RBI buys the securities from commercial banks in the open market, commercial banks sell it and get back the money they had invested in them. Obviously the stock of money in the economy increases. This way when the RBI enters in the OMO transactions, the actual stock of money gets changed. Normally during the inflation period in order to reduce the purchasing power, the RBI sells securities and during the recession or depression phase it buys securities and makes more money available in the economy through the banking system. Thus under OMO there is continuous buying and selling of securities taking place leading to changes in the availability of credit in an economy.

Cash Reserve Ratio Cash Reserve Ratio is a certain percentage of bank deposits which banks are required to keep with RBI in the form of reserves or balances .Higher the CRR with the RBI lower will be the liquidity in the system and vice-versa.RBI is empowered to vary CRR between 15 percent and 3 percent. But as per the suggestion by the Narshimam committee Report the CRR was reduced from 15% in the 1990 to 5 percent in 2002. Current CRR is 4.75% percent.

Statutory Liquidity Ratio Every financial institute have to maintain a certain amount of liquid assets from their time and demand liabilities with the RBI. These liquid assets can be cash, precious metals, approved securities like bonds etc. The ratio of the liquid assets to time and demand liabilities is termed as Statutory Liquidity Ratio. There was a reduction from 38.5% to 25% because of the suggestion by Narshimam Committee. The current SLR is 24%.

Bank Rate Policy Bank rate is the rate of interest charged by the RBI for providing funds or loans to the banking system. This banking system involves commercial and co-operative banks, Industrial Development Bank of India, IFC, EXIM Bank, and other approved financial institutes. Funds are provided either through lending directly or rediscounting of bill of exchange. Increase in Bank Rate increases the cost of borrowing by commercial banks which results into the reduction in credit volume to the banks and hence declines the supply of money. Increase in the bank rate is the symbol of tightening of RBI monetary policy. Bank rate is also known as Discount rate. The current Bank rate is 9%.

Repo Rate and Reverse Repo Rate Repo rate is the rate at which RBI lends to commercial banks generally against government securities. Reduction in Repo rate helps the commercial banks to get money at a cheaper rate and increase in Repo rate discourages the commercial banks to get money as the rate increases and becomes expensive. Reverse Repo rate is the rate at which RBI borrows money from the commercial banks. The increase in the Repo rate will increase the cost of borrowing and lending of the banks which will discourage the public to borrow money and will encourage them to deposit. As the rates are high the availability of credit and demand decreases resulting to decrease in inflation. This increase in Repo Rate and Reverse Repo Rate is a symbol of tightening of the policy. The current repo rate is 8% and reverse repo rate is 7%.

Fixing Margin Requirements The margin refers to the "proportion of the loan amount which is not financed by the bank". Or in other words, it is that part of a loan which a borrower has to raise in order to get finance for his purpose. A change in a margin implies a change in the loan size. This method is used to encourage credit supply for the needy sector and discourage it for other nonnecessary sectors. This can be done by increasing margin for the non-necessary sectors and by reducing it for other needy sectors. Example:- If the RBI feels that more credit supply should be allocated to agriculture sector, then it will reduce the margin and even 85-90 percent loan can be given.

Moral Suasion It implies to pressure exerted by the RBI on the indian banking system without any strict action for compliance of the rules. It is a suggestion to banks. It helps in restraining credit during inflationary periods. Commercial banks are informed about the expectations of the central bank through a monetary policy. Under moral suasion central banks can issue directives, guidelines and suggestions for commercial banks regarding reducing credit supply for speculative purposes.

Types Of Monetary policy

1.

EXPANSIONERY MONETARY POLICY TIGHT MONETERY POLICY

2.

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 with 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

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

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 signify 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 interestearning 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.

INTEREST RATE IN INDIA- AN INTERNATIONAL COMPARISION

The short term rate of interest in India has ususally been higher than the similar rate in other countries, especially W Germany & Japan. There does not exist a clear increasing or decreasing trend in the differential between the Indian and world short term rates. The long term rate of interest in India was mostly lower than the similar rate in other countries till 1985. Thereafter, the long term rate in India has been mostly higher than other countries. Thus, while both the short-term and long-term interest rates abroad have somewhat hardened in India since 1990. Both the short-term and long-term interst rates abroad have fluctuated more than those rates in India. The flexibility and variability of all interest rates in other countries have been far greater than in India.The short-term rate of interest has been more volatile than the long-term rate in all the countries including India.

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