7.9Summary

This chapter dealt with two questions – what determines the general level of interest

rates in the economy and what determines the structure of interest rates, in particular,

the term structure. We began by exploring the relationship between real and nominal

interest rates, arriving at the conclusion that the real interest rate is equal to the

nominal interest rate less the rate of ination. If the real interest rate were assumed

to be stable, nominal interest rates would vary from country to country only because

of differences in rates of ination. This still left us to explain why real interest rates

might be stable.

One way of doing this is through the loanable funds theory of interest rates in

which the real rate of interest is determined by the interaction of the demand for

loans and the supply of savings in a given period. The major determinants of the

real interest rate according to this theory are the marginal productivity of capital

(demand) and the willingness of people to postpone present consumption (supply).

The theory can be used to explain why, in the absence of international capital

mobility, real interest rates differ from one country to another. Even with interna-

tional capital mobility, real interest rates differ largely because of the existence of

risk premiums.

The loanable funds theory does not cope very well once the underlying assump-

tion of full information of future income, interest rates and prices is dropped. We

thus examined the liquidity preference theory in which interest rates are determined

by the interaction of the demand for and supply of money. Attempts are often made

to combine the two theories but they are essentially different – the loanable funds

theory helps to support the proposition that the market economy is stable; the

liquidity preference theory suggests that the market economy might be very unstable

and that government may have a role to play in stabilising the economy.

The second part of the chapter dealt with the term structure of interest rates –

the relationships among interest rates on bonds with different periods to maturity.

We explained the expectations theory in which current interest rates on bonds with

longer periods to maturity depend on expectations of future changes in interest rates.

We went on to consider term premiums based on aversion to capital and income

risk. We looked at the ideas of market segmentation, which raises the possibility that

the relationship between short-term and long-term interest rates is not very close,

and preferred habitat, which is a compromise between market segmentation and the

view that changes in short-term rates lead instantly to changes in long-term rates.

The chapter concluded with a consideration of the policy signicance of the term

structure of interest rates.

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Answer to exercise

Questions for discussion

1	How would you expect an increase in the propensity to save to affect the general levelof interest rates in an economy?

2	Explain how an increase in the rate of ination might affect (a) real interest rates and(b) nominal interest rates.

3	Why are some lenders capital risk averse and others income risk averse? What slopewill the yield curve have when the market is dominated by capital risk aversion?

4	Why might interest rates payable on long-term, ‘risk-free’ government bonds includea term premium?

5	Look at the most recent interest rate change by the MPC of the Bank of England and consider how quickly other interest rates in the economy changed thereafter. 1/4 Why does the MPC change interest rates each time it acts by only or, at most, 1/2a per cent?

6	Could the MPC of the Bank of England raise interest rates when everyone was expect-ing them to fall?

7	Look at the nancial press and nd the current interest spread between ve-year andten-year government bonds. Is there a positive term premium?

8	What conclusion might you draw about possible future interest rates if a positive termpremium were to increase?

Further reading

A D Bain, The Financial System(Oxford: Blackwell, 2e, 1992) chs. 5 and 6

P Howells and K Bain, The Economics of Money, Banking and Finance. A European Text

(Harlow: Pearson Education, 2005, 3e) chs. 9 and 10

K Pilbeam, Finance & Financial Markets(Basingstoke: Macmillan, 2e, 2005) ch. 4

Financial Times(FT.com) website, http://www.ft.com

Answer to exercise

7.1Six-year bonds: 9 per cent; seven-year bonds: 9 per cent; eight-year bonds: 9.5 per cent.

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CHAPTER8

Foreign exchange markets

Objectives

What you will learn in this chapter:

lHow exchange rates are expressed

lThe nature of the relationship between spot and forward rates of exchange

lThe meaning and signicance of purchasing power parity

lThe various explanations of exchange rate changes

lThe arguments for and against xed exchange rates

lThe arguments for and against monetary union

lAn explanation of the performance of the euro since January 1999

lThe issues surrounding the UK’s decision regarding euro area membership

The increasing interdependence of countries in recent years has led to a dramatic

growth in the proportion of nancial transactions that have an international aspect.

At the same time, major international imbalances and the volatility of exchange

rates have led to the development of new nancial instruments and the growth of

markets in which they are traded.

As exports and imports have grown as a percentage of the GDP of all developed

countries, so too has the proportion of rms earning foreign exchange and/or

requiring foreign currencies to purchase intermediate or nal goods. Such rms

necessarily are exposed to foreign exchange riskresulting from variations in exchange

rates. Firms have sought both to protect themselves from this risk and to seek prots

through speculation on currency markets. The desire to protect against risk has led

to the development of markets designed to provide insurance (forward and futures

and options markets) and the exploitation of techniques such as currency swaps. At

the same time, much attention has been paid to the need to forecast future changes

in exchange rates. This has in turn produced a great deal of debate over the nature

of foreign exchange markets.

Only a small part of the explosion in foreign exchange transactions can, however,

be related in any way to the needs of international trade. A much higher propor-

tion has derived from the great increase in international capital mobility that has

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