Determining Interest rates in the Money Market

Section 3 (60 grades)

Explain in detail how interest rates are decided in the amount of money market. Examine the likely consequences for the macroeconomy of a decrease in the rate of interest and showcase the factors that may limit the effects.

This essay is going to demonstrate how the rate of interest is set in the money market. It will analyze the impact a reduction in the interest is wearing the market. The framework used will be the interest rate mechanism, where a rise in the amount of money supply will change interest rates and promote interest-sensitive expenditures. It'll then point out the factors that can limit and offset the effects of a reduction in the interest rate.

The interest is described by Sloman et al. (2012) as the price payed for borrowing money. Two factors that determine the interest is the way to obtain money and the demand for money. The way to obtain and demand for the money throughout the market interact together to reach a level of equilibrium. Regarding to Sloman et al. (2012) the money market is a market for short-term credit debt instruments where finance institutions are active individuals. Shape 1 and 2 illustrates the amount of money market and the demand for money. The demand for the money refers to a person's desire to hold their wealth by means of money instead of using it to acquire goods or financial investments. The money demand curve is downward sloping as a rise in the interest contributes to a decrease in the quantity of money demanded. Money resource is the complete stock of currency and other liquid musical instruments in the economy. The money resource is set by the central standard bank (Bank or investment company of Britain) and is exogenous (will not be based upon the demand for money). The amount of money supply is set and is also not affected by the rate of interest. In shape 1, the x-axis measures the money resource, the y-axis stand for the interest and the L curve symbolizes the liquidity inclination curve (demand for the money). The amount of money supply is symbolized by the vertical lines Ms. The intersection of the money source and money demand curves reveals the equilibrium interest and is set at that time where they equate. Corresponding to Keynes the intersection of the curves is solely a monetary trend.

John Maynard Keynes (1936) in his publication the General Theory of Career, Interest and Money detailed the demand for money through liquidity inclination framework. According to this theory, the primary reasons for retaining money are for transactional, precautionary and speculative requirements. The sum of most three demands make up the total demand for money. According to the theory, if rates of interest are high individuals demand for money (liquidity choice) is low and when rates of interest are low, the demand for having money rises. In figure 2, the curve L1 is the deal plus precautionary demand for having money. L means the liquidity choice and by meaning; the liquidity inclination is the demand for positioning assets in the form of money. L is the full total demand for the money balances and is derived by the horizontal addition of curves L1 (the transactions plus precautionary demand for money) and L2 (the speculative demand for the money). The change from L1 to L2 illustrates a switch in the liquidity inclination (a rise in the demand for holding assets in the form of money).

The interest system is graphed in a three-stage process. Level 1 illustrates the money market, where an increase in the amount of money source from M to M' (with the rest being identical) leads to a land in the interest from r1 to r2. At level 2, the show up in the interest rate leads to an increase in the level of investment from I1 to I2. The increase in the level of investment translates in the third diagram shown in stage 3. Lower rates of interest increases investment as it becomes relatively cheaper for businesses to invest and businesses to obtain loans to financing increased spending and investment. Level 3 shows how a climb in investment contributes to a multiplied surge in the nationwide income from Y1 to Y2. Stage 3 shows the Keynesian withdrawals and shots function where a rise in investment has increased the level of shots J1 to J2. This extra in shots over withdrawals will lead to a rise in the nationwide income from Y1 to Y2. Interestingly, a rise in the level of income means that consumers will have more disposable income for usage purposes (Sloman et al. 2012).

Consumption is the most significant component of aggregate demand and has an effect on other the different parts of aggregate demand such as online exports and investment Griffiths and Wall (2007). Lower interest rates increases the degree of consumption by making the chance cost of consumption is leaner. This encourages increased expenditure as borrowing through bank cards becomes cheaper. Lower rates of interest makes saving less attractive by lowering an individual's incentive to save lots of. This lower incentive to save lots of encourages consumers to spend rather than to carry onto money. It also reduces the income from personal savings and the interest that arrives on loans taken out. However, borrowing now becomes more attractive which stimulates a rise in spending. Lower Interest levels can boost the costs of investments such as shares and houses. Higher house prices means that current home owners must extend their home loans which further permits them to financing higher consumption. Interestingly, the higher advantage prices escalates the wealth of homeowners (through the wealth effect) which heightens their incentive to invest as assurance will be higher. Higher property prices means that companies are also in a position to finance their investment (purchase of capital) at a lower cost. Lower rates of interest also reduces the price tag on interest repayments on home loans by lowering the regular cost of mortgage repayments. This escalates the disposable income of householders which enhances their degree of spending. In addition, lower interest can reduce the value of the Pound Sterling. If UK interest rates fall relative to overseas, saving money in UK becomes less attractive as higher results can be earned in another country. This reduces the demand for the pound sterling and causes the decrease in the worthiness. In number 6 at stage 2, the land in the currency is due to a decrease in the demand for the Pound Sterling in market. The surge in the supply of the domestic currency from S1 to S2 contributes to a show up in the demand for the currency from D1 to D2 and this triggers a depreciation in the exchange rate from er1 to er2. This street to redemption leads to a rise in the demand for exports as UK exports become relatively cheaper and more appealing overseas. There may also be a fall popular for imports (as they are more expensive) and so causing an increase in the nationwide income (which further raises spending).

What if other factors can offset the entire extent of a decrease in interest levels? There can be found time lags throughout the market that can limit the impact of rate reductions on the particular level on interest-sensitive expenditures. In body 4, the increase in the money supply business lead to a multiplied effect and led to a rise in the countrywide income. However, the system failed to emphasize how a go up in income will also lead to a growth in the transactional demand of money (L1). On this circumstance, at level 1, L1 would alter to the right and therefore lead to a smaller fall in the interest rate than illustrated. Thus, the amount of investment at level 2 and the nationwide income at stage 3 will not rise around shown as well. The entire effect of the amount of money supply on national income will depend on the size of each stage. Their relative sizes rely upon the designs of the liquidity inclination and investment curves (such as shape 6 and 7). A bigger change in the interest will be caused if the liquidity desire is less stretchy. The more interest-elastic the investment curve is, the larger the change in investment. When the marginal propensity to withdraw is leaner and then the curve is flatter, this may cause a larger multiplied change in the countrywide income than illustrated (Sloman et al. 2012).

Keynesian economists stress how volatile periods 1 and 2 are in the interest rate mechanism. What if increasing the amount of money supply causes no interest rate reductions? What if investment is inelastic and can't be influenced by changes in rates. Body 6 illustrates an stretchy liquidity inclination curve. The less elastic the liquidity inclination is, the bigger the change that'll be induced in the interest rate. Because of its lightly sloping curve, a growth in the amount of money resource from M to M' will lead with an only small fall season in the interest rate. This will likely them limit the impact that the interest has on consumption, keeping decisions and another interest-sensitive expenditures. Corresponding to Keynesians, the demand for the money (L) can be very stretchy in response to changes in the interest levels and the liquidity preference curve can become relatively flat. The entire effect of a rate cut can be limited greatly by the nature of the demand curve. At r2, if individuals understand and expect no further rate reductions, any increase in the money (from M' to M'') will have no impact on r. The liquidity snare is where Keynes believed this additional money will be lost in. in this theory, rates of interest have a floor where an increase in the money supply does not have any further impact. The financial crisis 2008-09 was a predicament where insurance plan designers feared that increases in the money resource will lead to idle balances lost in the liquidity snare. The central standard bank used an unconventional financial coverage known as quantitative easing, where they intentionally increased the base rate via the purchase of bonds and other securities in trade for money. This technique of credit creation was used to increase bond prices and so reduce the interest rate and stimulate development. Arguably, increases in the amount of money supply will have some impact on the interest as we have seen in the financial meltdown where deliberate raises in the amount of money supply lead to further raises in the interest rate and so spending as well (Sloman et al. 2012). Shape 8 illustrates the result on interest rates of an unpredictable liquidity preference curve. This shape further explains how the liquidity choice curve fluctuates anticipated to factors such as goals in the inflation rate and way of the interest rate (to mention a few). Therefore, due to its instability it is difficult to anticipate the effect on interest levels of an change in the amount of money supply.

Another factor that can affect the investment program are changes in trader confidence. An increase in investor self-assurance can change the investment curve to the right and at any given interest levels, firms would want to invest more. A reduction in their self-confidence would move the curve left. If investors believe that the economy will escape recession, their assurance and level of investment will increase. If firms believe inflation will climb and that the central lender will soon boost the interest rate, confidence and investment throughout the market will be low (Sloman et al 2012). In Figure 7, a bigger change in investment will be triggered if the investment curve is more interest-elastic. In the liquidity preference construction, investment demand is unresponsive to interest rate changes and this a sizable change in the interest is detrimental to affect investment. Evidence to confirm this is illustrated through the impact of entrepreneur confidence. This consensus on the behaviour of investment can be argued for the reason that the concentrate should be more about how volatile and erratic investment is response to assurance than its responsiveness to the interest. For instance, in body 9, the impact of the fall in interest rates is bound by business confidence. Initially, the decrease in the interest rate has increased investment. However, if the street to redemption in interest levels is accompanied by an increase running a business confidence by shareholders, the investment curve will move from l1 to l2. Alternatively, if the street to redemption in the interest rate is along with a decrease in self confidence then the investment curve will reduce and fall shift from l1 to l3. This impact is contrary to that which was illustrated when the investment curve was thought to be inelastic. Therefore, expansionary financial policy is likely to be more effective if firms have confidence in its performance (Sloman et al. 2012).

In the liquidity inclination framework, the assumption is an increase in the amount of money supply contributes to lower interest levels if everything else remains identical. However, the truth is a rise in the amount of money source might impact other factors throughout the market that could increase the interest rate rather than lowering it. Two factors to highlight will be the income result and the price-level impact. The income impact describes how a rise in the amount of money supply comes with an expansionary effect on the economy and this in effect raises the national income and riches. The liquidity choice theory predicts that an upsurge in the national income and wealth will increase the interest and offset the initial impact of an increase in the money supply. Another effect that can limit the impact of a reduction in interest levels is the price-level effect. In this result, a rise in the amount of money supply increases the overall price level which also escalates the interest.

In final result, economics is a public science where theories are constantly analyzed and redrafted. Inside the interest rate system theory, an increase in the amount of money resource will lower interest levels and induce interest-sensitive expenses. This stimulation will have a multiplied influence on the level utilization, business investment, mortgage repayments and property prices. However, the impact of a reduction in the interest on the market is a significant complex at the mercy of address. Many determinants must be factored in for the entire impact to be noticeable. Even if the overall effect of a decrease in the interest rate is very good, it is highly unpredictable to assess and calculate the magnitude of it. Investment is affected by self-assurance and on elasticity to the interest rate. This changes the original impact of a rate cut. The nature liquidity preference curve can be highly unstable and not be impacted by any changes in the interest rate. There also other factors like the price-level, objectives and income that can impact and offset the supposed purpose of a rise in the money supply.

All the factors highlighted in this essay can limit and offset the impact of a reduction in rates of interest on interest-sensitive expenses and the development of the economy.


Keynes, J. M. (1936), THE OVERALL Theory of Career, Interest and Money, CreateSpace Indie Publishing Platform

Griffiths, A. and Wall membrane, S. (2007) Applied economics, 11th ed. Harlow: Addison Wesley Longman.

Sloman, J. , Wride, A. and Garratt, D. (2012) Economics, 8th ed. Harlow: Pearson Education Small.


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http://www. macrobasics. com/chapters/chapter8/lesson83/

http://harbert. auburn. edu/~thommsn/FINC-3700/ME7-WebChapters/WebApp04_4. pdf

http://www. stlouisfed. org/publications/re/articles/?id=2505

http://www. bankofengland. co. uk/publications/Documents/quarterlybulletin/qb120104. pdf

https://www. creditwritedowns. com/2010/10/on-liquidity-traps-and-quantitative-easing. html

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