7.6 The monetary authorities and the rate of interest

The standard model of this kind continues to assume that the monetary authorities

are able to control the supply of money. The money supply curve can be drawn as

either vertical (as it is in the simplest version of these theories) or, as here, as sloping

up steeply to the right. The interaction of the demand for money and supply of money

curves then determines the interest rate.

7.5Loanable funds and liquidity preference

Much effort has been put into trying to show the relationship between the two

principal theories of interest rate determination – loanable funds and liquidity pre-

ference. It is commonly argued that the two theories are, in fact, complementary,

merely looking at two different markets (the market for money and the market for

non-money nancial assets), both of which have to be in equilibrium if the system

as a whole is in equilibrium. Although it is true that, in a technical sense, the two

theories can be assimilated, this is done at the cost of losing the spirit of both theories.

Let us see why this is so.

Let us assume that there is a sudden, unexplained loss of condence in nancial

markets, causing an increase in the demand for liquidity. The demand for money at

each level of interest rates increases and the demand for money curve in Figure 7.2

shifts out from MDto MD. Interest rates rise from ito i. In the nominal interest rate

1212

version of the loanable funds theory, this is expressed as an increase in the demand

for liquid reserves, and the demand for loanable funds curve shifts up, also causing an

increase in nominal interest rates. So far so good, but this sudden change in con-

dence would be regarded by loanable funds theorists as irrational behaviour. In other

words, it would either not occur or would be seen as temporary and unimportant in

an explanation of how the economy operated.

Remember that, in our discussion of the loanable funds view, we suggested that

any instability in interest rates would be caused by the behaviour of governments or

central banks. In liquidity preference theory, on the other hand, instability is inherent

in the market economy and there is a possible role for government in stabilising

the economy. This argument that the two theories are essentially very different is

carried further the next section when we consider the implications of the two theories

for monetary policy.

7.6The monetary authorities and the rate of interest

We saw in Chapter 5 and in Box 7.1 that the general level of interest rates might

change in an economy because the monetary authorities change the rate of interest

at which they are prepared to operate in the money market. This is usually done in an

attempt to inuence the level of aggregate demand in the economy (and hence the

rate of ination) or the net inow of short-term capital into the economy (and hence

the exchange rate). Section 5.3 deals in some detail with the operation of monetary

policy and with recent changes in the practice of monetary policy in the UK.

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Chapter 7 • Interest rates

In Chapter 5, we pointed out that the ability of the monetary authorities to

inuence very short-term interest rates in the economy derives from the role of the

central bank as the lender of last resort to the commercial banking system. The need

for central banks to operate in this way arises from the fractional reserve nature of the

banking system (explained fully in Chapter 3) and the desire of banks to keep the

average rate of return on their assets as high as possible. Thus, they seek to economise

on their holdings of liquid, low-interest assets. However, the fractional reserve system

means that banks can easily nd themselves short of liquid assets (reserves) as the

result of unexpected withdrawals by depositors. The monetary authorities are able

to exploit this need of banks to maintain a sufcient stock of reserves by being will-

ing to replenish bank reserves, but only at a price determined by the central bank.

Section 5.3 lists the three ways in which central banks might allow banks to achieve

the degree of liquidity needed to meet the demands of their depositors while still

keeping the average rate of return they receive on their assets high – use of the dis-

count window, open market operations, and repurchase agreements.

Variations by the central bank in the interest (or discount) rate at which it is pre-

pared to lend very short term to the commercial banks inuence the form in which

banks hold their assets and, in particular, their willingness to make loans to their

clients. This then affects longer-term interest rates. This ability of the central bank to

inuence the general level of interest rates does not, however, mean it fully controls

rates of interest. There are several reasons for this.

Firstly, the notion that the central bank can inuence the willingness of banks to

make loans assumes that banks are prot maximisers and thus that any small change in

the costs of a liquidity shortage causes a response from banks. The behaviour of banks

certainly shows that they are interested in keeping prots high, but they are also likely

to have other objectives. For instance, they may wish to maintain their share of the

different markets in which they operate. Banks are in competition with each other for

both assets (including competing with each other in the house mortgage market) and

liabilities (competition for bank deposits). In order to maintain their spread between

borrowing and lending rates, banks that cut their lending rates must also cut their

deposit rates. It follows that in a period of intense competition for bank deposits, such

as has occurred in the UK in recent years with the establishment of savings banks by

supermarket chains and insurance companies and the continued growth of telephone

banking, banks might judge that they cannot afford to lower immediately the rates of

interest they are offering on deposits. This might cause them not to respond imme-

diately to relatively small changes in the base interest rate of the central bank.

This implies that banks have a choice – to respond or not to the prompting of

the central bank. This arises because the larger banks possess a considerable degree

of market power. In a perfectly competitive system, all banks would respond to the

prompting of the central bank by being more willing to make longer-term loans

(including mortgage loans), and this would push down interest rates generally,

leading to an increase in borrowing and an increase in the total stock of deposits.

However, if the banks are more interested in their share of deposits than in the

volume of deposits, they might be unwilling to lower the interest rates they offer to

savers, even if that prevents them from lowering mortgage interest rates as well.

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