Interest rates

Objectives

What you will learn in this chapter:

lThe relationship between nominal and real rates of interest

l	The loanable funds theory of real interest rates and its adaptation to deal with nominal interest rates

l	The liquidity preference theory of interest rates and how it relates to the loanable funds approach

l	How the monetary authorities strongly inuence the general level of interest ratesin the economy

l	The meaning of the term structure of interest rates and the various theories usedto explain the term structure

We have seen many times that an interest rate is one form of yield on nancial

instruments – that is, it is a rate of return paid by a borrower of funds to a lender of

them. We can also think of an interest rate as a price paid by a borrower for a service,

the right to make use of funds for a specied period. We shall here be looking at

two questions:

(a)	What determines the average rate of interest in an economy? and

(b)	Why do interest rates differ on loans of different types and different lengths –that is, what factors inuence the structure of interest rates in an economy?

Of course, interest rates also vary depending on whether you are borrowing or

lending. For example, there is a spread between the interest rate at which banks are

prepared to lend (the offer rate) and the rate they are willing to pay to attract deposits

(the bid rate). There is also a spread between selling and buying rates in international

money markets. For example, the Financial Timesof 25 May 2006 quoted the interest

5

rate on short-term sterling in international currency markets as 4/8per cent (the

¹/2

offer rate) to 4per cent (the bid rate). If we wish to quote a single interest rate in

such a case, we can specify that we are referring to the offer rate or the bid rate – as

in the distinction between LIBOR (the London Interbank Offered Rate) and LIBID

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Chapter 7 • Interest rates

(the London Interbank Bid Rate). Alternatively, we can take the mid-point between

the offer and bid rates. Where the Financial Timesreports a single market interest rate

it gives the mid-point between the Offer and Bid rates. In our example above, the

⁹/16

mid-point is 4(4.56) per cent.

This spread between offer and bid rates covers the administrative costs of the

nancial intermediaries and provides prot for them. The spread is itself subject

to change and is likely to be smaller the greater the degree of competition among

nancial institutions. In the UK interest rates example above, the spread is small

1

(/8per cent) because there is considerable competition in short-term international

money markets. The spread between the rates at which banks borrow and lend to

their retail customers is generally a good deal greater. This spread also reects the

degree of default risk that lenders feel they are facing in making loans since the

lending rate (offer rate) will always include a risk premium.

Risk premium:An addition to the interest rate demanded by a lender to take into

account the risk that the borrower might default on the loan entirely or may not repay

on time (default risk).

In this chapter, we look rst at another important distinction in the expression

of interest rates – that between nominal and real rates of interest. We then go on

to consider the principal theories of the determination of the interest rate in an

economy. We begin with the well-established loanable funds theory of interest rates.

We later introduce Keynes’s liquidity preference theory, comparing and contrasting

this with the loanable funds approach. The second half of the chapter investigates

the structure of interest rates, notably the term structure and the yield curve, which

illustrates the term structure. The chapter concludes with an examination of theories

seeking to explain the different possible shapes of the yield curve.

The interest rate structure:Describes the relationships between the various rates of

interest payable in an economy on loans of different lengths (terms) or of different

degrees of risk.