7.6 The monetary authorities and the rate of interest

This element of rationing in the market for bank loans allows banks to vary the

amount of lending they do by changing the percentage of loan applicants they reject.

In other words, the supply curve of bank lending may shift because of changes in

the assessment made by banks of the future prospects of the economy. We might

even think of a kinked supply curve of new loans, indicating the higher risk premium

that banks require from customers classied as not such good risks. Such a supply

curve could even become vertical, to reect the fact that some demand for bank

loans will not be met at any rate of interest. This approach would allow the position

of the kink or the size of the risk premiums demanded to change depending on the

assessment made by banks of general economic prospects. This introduces additional

exogenous elements into the determination of interest rates.

In different ways and to different degrees both the loanable funds and the liquidity

preference theories of interest rates cast doubt on the power of the central bank.

According to loanable funds theory, the central bank has no effect on long-run real

interest rates. All it can do is to cause (or prevent) ination and hence inuence

nominal rates of interest. Monetary changes have no impact on real variables – money

is neutral. There may be short-run effects on real variables such as employment and

the real interest rate but these occur only to the extent that market agents suffer

from money illusion. That is, they confuse real and monetary variables, thinking

mistakenly, for example, that an increase in money wages implies an increase in real

wages although prices are rising at the same time.

This is not the case in the Keynesian model in which changes in interest rates

brought about by the central bank can have an effect on real values – money is

not neutral. However, doubts are raised about the size of that effect and about

the ability of the central bank to inuence the rate of interest. We pointed out

above that, in the standard form of Keynesian monetary theory, the money supply

is assumed to be exogenous. Assume, then, that the authorities increase the supply

of money. This would shift the supply of money curve in Figure 7.2 out to the right.

Interest rates would fall, but if this fall persuaded a signicant number of people

that interest rates were likely soon to go back up again, it might cause a consider-

able increase in the demand for money. In other words, a large proportion of the

increase in the supply of money might be held idly as liquid balances rather than

being lent on to rms and consumers wishing to borrow in order to spend. If this

is so, increases in the money supply might have a very small impact on interest

rates and hence on spending. In the extreme version of this argument, the liquidity

trap, liquidity preference is total – any increase in the money supply is matched

by an equivalent increase in the demand for money. Monetary policy has no effect

on anything.

This does not take us far since we know that central banks cannot and do not try

to control the money supply directly but act instead on short-term rates of interest.

Supporters of the ideas behind liquidity preference then adopt some of the arguments

above, suggesting that the actions of the central bank might not be fully reected

in interest changes throughout the economy. The practice of credit rationing by

banks is held to be particularly important in this regard. In addition, if the central

bank does succeed in bringing about a change in interest rates, the effects might not

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Chapter 7 • Interest rates

be very great since the rate of interest is only one factor inuencing investment

and consumption. Factors inuencing how condent people feel about the future

are likely to be more important. All of this is particularly true when economies are

in deep recession. The central bank is thought to have more power to help to deate

inationary economies by pushing up interest rates than to help drag economies out

of recession by pushing down interest rates.

We need to add, however, that the very large increase in home ownership and

the generally large increase in personal indebtedness in recent years has led to the

view that the power of the central bank to affect the economy through its inuence

on interest rates has increased sharply. Box 7.2 summarises the many factors that

we have suggested might have an inuence on nominal interest rates.

Box 7.2

Inuences on nominal interest rates

The following list puts together all of the factors discussed in this chapter which might

have an inuence on nominal interest rates:

1	The marginal productivity of capital.
2	The average time preference of the population.
3	Business condence.
4	The economy’s wealth.
5	Expectations regarding future changes in asset prices.
6	Expectations regarding the future performance of the economy.
7	Expectations regarding future interest rates.
8	Expectations regarding future exchange rates.
9	The rate of ination.
10	Expectations of changes in the rate of ination.
11	The volatility of ination.
12	The short-term interest rates set by the monetary authorities
13	The degree of competition among nancial institutions.
14	The international mobility of capital.
15	Changes in the degree of risk aversion in the economy.

Have we left anything out?

Do you understand where each of these ts into the argument?

Which three factors do you think are most important?