Interest Rates: The Price of
Decomposition of interest rates
For those of you who have paid for your tuition with a student loan, your clothes with a credit card, and your car with a car loan, as well as those of you grew up in a home purchased with a mortgage, interest rates matter. They also matter to those who have some savings in a bank account, money invested in the stock market, or friends or family members employed in the construction or real estate businesses. If interest rates rise, you are likely to feel a negative effect if you are borrowing money and a positive effect if you are lending money. It is no surprise then that when interest rates change there are winners and losers, which is why there is so much interest in the ability to explain and forecast interest rates.
To fully understand interest rates you would need to invest a considerable amount of time learning the details of the capital market, but fortunately you can gain considerable insight into interest rates with a modest investment of your time and effort. As you follow interest rates in the financial press you should keep in mind there are many interest rates. There are rates on your student loan, car loan, credit cards, and bank account you care very much about, and rates on government securities, corporate bonds, mortgages, and bank borrowing that policy makers care about. At this time you will not be expected to know all of the various rates, but there are a few rates you need to know a little bit about as you sort through the financial press and the discussions in class. The rates listed below would be included on the short-list of important rates.
The first two are always mentioned when you hear discussions of the Fed's monetary policies. The discount rate is the rate the Fed charges banks to borrow money overnight, while the federal funds rate is the rate on an overnight bank loan between banks. These are the rates the Fed lowered in the early 1990s to help get the economy out a recession; raised in the mid 1990s to slow down an economy that many perceived as overheated and on the verge of renewed inflation; lowered in the late 1990s to help keep the US economy from falling into a recession caused by the Asian crises, and raised in early 2000 to ward off inflation. The second two are good measures of the cost of funds - how much the private sector's best customers must pay for money and how much the government pays for short-term borrowing. In the case of the government, when it runs a deficit it must borrow money which it does by issuing bonds and securities (government IOUs). It is the interest rate on these bonds that we look up on the pages of the Wall Street Journal.
The final rate is just one of an array of consumer / household related interest rates. Others would be the rate on car loans and credit cards. The mortgage rate is often times looked at as an influence on the housing industry. When this rate rises it is often accompanied by stories describing the chilling effect it will have on new home construction (housing starts) and home sales. When interest rates rise, monthly payments increase which should lower demand for the mortgages. When the interest rate rises some individuals will simply drop out of the market unable to afford the higher payments. You can see the link between interest rates and monthly payments by checking out one of the on-line calculators.
When trying to understand the differences between interest rates, it is useful to think of each interest rate as being the sum of a number of separate components. You do not expect a bank to charge you the same interest rate that it charges General Motors, Microsoft, the state of Rhode Island, or the federal government? Would the bank charge the government the same rate to borrow money for 6 months and 30 years? I suspect you will agree that the bank will not charge the same rate for all borrowers, but why are they different? Maybe because you would not expect the price of a 20 Watt CD player to be the same as the price of a 100 Watt player, or a two bedroom apartment overlooking the water to be the same as a studio apartment with a view of the next building. Students have never had problems seeing the differences between the CD players and the apartments and in predicting differences in prices. With a CD player, one would be willing to pay for more power, while for apartments we would pay more for the view.
The same is true with interest rates. An interest rate is the price of borrowing, and not all borrowing is the same. For example, you would charge less to a borrower you were confident could repay the loan. You would also charge more if you expected dollars to be worth less when the loan was repaid at some time in the future. When you look at interest rates, therefore, you should think of them as reflecting a number of important criteria that affect the lenders' decisions because they affect the lender's perception of risk. These are things the lender considers when deciding on how much to charge for lending money. One such set of criteria appear below.
A Decomposition of Interest Ratesr = ri + rd + rl + rm+ rr
On the left side of the equation is the nominal interest rate (r) - the rate you will hear quoted to you or the rate you will see in the financial press. This rate can be conceptually decomposed into five separate components - the first three of which are described in more detail (inflation effect, default risk effect, maturity effect).
The interest rate you pay will depend on what the lender expects inflation to be (ri) - what we will call inflation risk. If you expect prices will rise 10 percent in a year, you certainly will want to have this reflected in the interest rate charged. Anything less than 10 percent will leave the lender with less buying power at the end of a year. If the lender wanted 3 percent for lending you money, then when inflation is 10 percent, the interest rate should be 13 percent. The Savings & Loan crisis in the US in the 1980s can be attributed in large part to a dramatic shift from a low inflation, low interest rate environment to a high inflation, high interest rate one. Those lenders that were locked in at low rates were real losers when the rates rose.
The lender will also consider the likelihood a loan will ever be repaid. The Asian crises in 1998 revealed the importance of this effect. As the crises spread and lenders became very concerned about the ability of governments in Asia, Latin America, and Russia to repay their debts after Russia defaulted on its debt, interest rates rose above 30 percent in a number of countries at a time rates in the US were about 5 percent. This was the risk, or default premium (rd) charged to cover the additional risk if the debts would not be repaid. You may have also heard of junk bonds. These are simply bonds issued by smaller, or newer companies where there is a greater perceived risk of being repaid and this risk is reflected in the higher interest rates.
The rate charged will also depend upon the length of time of the loan. The longer the loan, the more likely something will go wrong - either the lender comes up short of funds, a better opportunity surfaces, the borrower falls upon bad times, or the economic environment changes dramatically. If you look in the newspaper, call your bank, or check out rates on-line, you will note the mortgage rate is higher for 30-year mortgages than it is for 15-year mortgages. This is the maturity risk (rm).
And then there is the ease with which you can turn the loan into cash - liquidity risk (rl). All other things equal, you will pay less for money if the asset backing it is easily tradable. This is one of the reasons why government Treasury bills and bonds have low rates - there are very well developed markets for them and you can easily and inexpensively turn them into cash. The same would not be true of a loan that you made to a local business or a friend. You would be 'stuck' with these rates until the term of the loan expired, even if you did need the money, and thus you would expect to be compensated for taking on the greater risk.
Finally, there is the base rate of money (rr). You might hear of this as the risk-free, real rate of interest. All other rates will include premiums for the other effects. There is no direct measure of this rate, but in recent years the Treasury has begun to issue inflation-indexed bonds. Normally a government bond will have a quoted rate that the lender can expect to be paid - a 5 percent rate will give the lender $5 on every $100 lent out. These inflation-indexed bonds are a bit different, because there is no set interest rate. The lender agrees on a certain rate PLUS any inflation that occurs over the duration of the loan. For example, if the rate is 2 percent and inflation is 3 percent, then the interest that will be paid at the end of the year will be 5 percent. On this security, the inflation risk has been eliminated and, given that these are Treasury bonds, so has the liquidity and default risks. The only difference between this and the base rate would be a maturity effect since these bonds are five and ten-year bonds.
How do you reconcile the facts that in economics courses we talk about an interest rate while in the financial press we can find information on many interest rates? Economists can ignore the distinction between interest rates in our discussions of rates because they expect all rates will move together, although the fit is not a perfect one. When we talk about interest rates rising in our class discussions, you should expect the rates on loans, credit cards, home mortgages and bank accounts to all be rising. This is why you will note the last three rates in the above list often get mentioned at the time the Fed changes the discount or federal funds rate - any Fed policy is assumed to have a ripple effect on all rates, which is precisely the reason we do not focus on individual rates.
The relationship between various interest rates is evident in the graph below where you see interest rates on three types of loans: loans to local governments (municipals), loans to low risk corporations (AAA), and loans to the federal government (GS). The rates on all three loans generally rose until the early 1980s at which time they began a general decline. It is easy to see in this diagram that when we talk about an increase in interest rates, the increase can be seen in all of the individual rates.
Now that we know there are a large number of rates and the rates tend to move together, we can address the issue of explaining these rates. The best place to start is recognizing interest rates are prices, and given the previous discussions of prices, it should be no surprise we will use the Supply-Demand model to explain interest rates.
Model of interest rates
The starting point in any analysis of interest rates is the recognition that they are prices - and as prices the best way to understand them is with the supply and demand tools we learned earlier . We have used the supply - demand model to explain wages, stock prices, and exchange rates and now we will use it to explain the price of money. The graphical version of the Supply - Demand model of the money market appears below.
While we will not embark on an extensive review of the Supply and Demand model of prices, you should review the cookbook approach. The important steps in the approach are:
A schematic of the cookbook approach to the money market appears below. The market is the market for money in which the interaction of suppliers (Fed and banks) and demanders (individuals and firms) determines the price (interest rate). In the remainder of this section we will fill in some of the details concerning the "Players" in the market.
A Schematic of the Money Market
We will begin our analysis of money and interest rates with a treatment of money demand based on the work of Keynes. This will be followed with a discussion of the money supply process which will include a discussion of the Fed, the central bank of the US, and the process of money creation that links the Fed, banks, and the money supply. When we are done you should be able to explain past interest rate movements and / or forecast future interest rate movements.
Why do people want / demand money? As you will recall from our earlier discussion of the Classical economists (1930s), money was traditionally viewed as simply a medium of exchange. Money had no intrinsic value so people demanded money simply to facilitate their transactions - if they had money they would spend it, and if the volume or price of their transactions increased, they would need more money. This transactions demand is described in the Transactions Demand schematic below where more income leads to more transactions which leads to demand for more money.
Transactions Demand for Money
|Higher Income||Þ||More Transactions||Þ||More Money Demand|
Keynes, took a somewhat different view of money, a more general view where he specified three reasons for holding money - transactions, precautionary, and speculative motives. The first of these was simply the old Classical view - more transactions means more money demand. It was the last of these that was the real innovation, the Keynesian contribution. Keynes believed money should be viewed as an asset similar to the other assets people own - bonds, stock, and real estate. Furthermore, individuals would be expected to continually alter their portfolio of assets to maximize the expected return. If you read the financial press you will always hear financial gurus telling investors how much of their wealth to keep in stocks, how much in bonds, gold, and cash. Keynes was anticipating this literature.
The logic behind Keynes' speculative demand is simple: if interest rates are low people will not lose much money in foregone interest by holding a portion of their wealth as cash. If you happen to have $1,000 and hold it as cash, then you will be giving up the opportunity to earn $100 when the interest rate is 10%. If the interest rate falls to 5%, then by holding cash you will be giving up the opportunity to earn $50. You would expect as interest rates rise people will tend to hold less of their wealth as money and more as interest earning assets. The "demand" for money will thus be lower at the higher rates, which is what you see in the Speculative Demand schematic below.
Speculative Demand for Money
|Higher Interest Rate||Þ||Higher Opportunity Cost of Money||Þ||Lower Money Demand|
If we combine the two effects we will have money demand being dependent on interest rates and the level of transactions, which is assumed to be related to the level of income. Money demand is positively related to the level of income and negatively related to interest rates. The demand for money can be demonstrated with a traditional demand curve that captures the negative relationship between interest rates (price of money) and money demand [Diagram 3]. As the interest rate rises from i* to i**, the demand for money will fall from M* to M**.
Keynesian Money Demand
This is not the end of the story. Money demand for transactions purposes depends on income and an increase in transactions resulting from an increase in income, possibly the result of the economy moving out of a recession into the expansion phase of the business cycle, will show up as an outward shift in the money demand curve (D to D*).
Increase in Money Demand
Now that we have looked at the demand-side of the market, we need to add in the supply side of the market and then put them together to discuss the price of money. We will begin with a simple discussion of the complete model and then shift to a more thorough treatment of the supply-side - one that emphasizes the role of the Fed and banks and the creation of money. For now we will assume that the money supply curve looks like all other supply curves - positively sloped - and that the Fed can move the curve in (decrease money supply) or out (increase money supply).
Supply and Demand in Action: Comparative Statics
Let's put yourself in a position to forecast interest rate movements. What will happen to rates if the economy heats up as it begins to move out of a recession and into the expansion phase of the business cycle? What happens if the Fed decides to increase the money supply? An expanding economy means higher production (GDP) which translates into higher incomes. This shows up as an outward shift in money demand - people want to spend more so they need more money. The result, seen in the left-side graph in Diagram 5, is an increase in interest rates. If the Fed increases the money supply, using tools we will discuss in the next section, the money supply curve shifts out as in the right-side graph. The result will be a decrease in interest rates.
Money Market: Comparative Statics
Once we have accepted the fact that interest rates are prices, we can make generalizations concerning of the impact of external shocks on these rates. For any shock that can be translated into a shift in the supply or demand curve, the impact on price (interest rates) and quantity (money) can be forecast using the table below which is simply a restatement of what we saw earlier in the analysis of supply and demand.
Money Market: Comparative Statics
Now it's time to move on to a more complete treatment of money supply including a discussion of the behavior of the Federal Reserve and commercial banks that play a key role in the money supply process.