The Equilibrium Interest Rate | CBCS

Almost all financial markets clear—that is, almost all reach an equilibrium where quantity demanded equals quantity supplied. In the money market, the point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy. This explanation sounds simple, but it requires elaboration.

Supply and Demand in the Money Market

The  Fed or Central Bank controls the money supply through its manipulation of the amount of reserves in the economy. Because we are assuming that the Fed’s money supply behavior does not depend on the interest rate, the money supply curve is a vertical line. In other words, we are assuming that the Fed uses its three tools (the required reserve ratio, the discount rate, and open market operations) to achieve its fixed target for the money supply.

Adjustments in the Money Market- Equilibrium exists in the money market when the supply of money is equal to the demand for money and thus when the supply of bonds is equal to the demand for bonds. At r0 the price of bonds would be bid up (and thus the interest rate down), and at r1 the price of bonds would be bid down (and thus the interest rate up).

Figure superimposes the vertical money supply curve from Previous figure on the downward-sloping money demand curve. Only at interest rate r* is the quantity of money in circulation (the money supply) equal to the quantity of money demanded.

When the Central Bank(Fed) fixes the money supply it also fixes the supply of bonds. The decision of households and firms is to decide what fraction of their funds to hold in non-interest-bearing money versus interest-bearing bonds. At the equilibrium interest rate r* in Figure, the demand for bonds by households and firms is equal to the supply. Consider r0 in Figure, an interest rate higher than the equilibrium rate. At this interest rate households and firms would want to hold more bonds than the Fed is supplying (and less money than the Fed is supplying). They would bid the price of bonds up and thus the interest rate down. The bond market would clear when the price of bonds fell enough to correspond to an interest rate of r*. At interest rate r1 in Figure, which is lower than the equilibrium rate, households and firms would want to hold fewer bonds than the fed is supplying (and more money than the Fed is supplying). They would bid the price of bonds down and thus the interest rate up. The bond market would clear when the price of bonds rose enough to correspond to an interest rate of r*.

The Effect of an Increase in the Supply of Money on the Interest Rate-An increase in the supply of money from to lowers the rate of interest from 7 percent to 4 percent.

Changing the Money Supply to Affect the Interest Rate

With an understanding of equilibrium in the money market, we now see how the Central Bank(Fed) can affect the interest rate. Suppose the current interest rate is 7 percent and the Fed wants to reduce the interest rate. To do so, it would expand the money supply. The Above Figure shows how such an expansion would work. To expand M, the Fed can reduce the reserve requirement, cut the discount rate, or buy U.S. government securities on the open market. All these practices expand the quantity of reserves in the system. Banks can make more loans, and the money supply expands even more. In Figure, the initial money supply curve, shifts to the right, to At the supply of bonds is smaller than it was at . As the money supply expands from to , the supply of bonds is decreasing, which drives up the price of bonds. At the equilibrium price of bonds corresponds to an interest rate of 4 percent. So the new equilibrium interest rate is 4 percent. If the Fed wanted to increase the interest rate, it would contract the money supply. It could do so by increasing the reserve requirement, by raising the discount rate, or by selling U.S. government securities in the open market. Whichever tool the Fed chooses, the result would be lower reserves and a lower supply of money. The supply of money curve in Figure would shift to the left, and the equilibrium interest rate would rise.

Increases in P Y and Shifts in the Money Demand Curve

Changes in the supply of money are not the only factors that influence the equilibrium interest rate. Shifts in money demand can do the same thing. The demand for money depends on both the interest rate, r, and nominal income (P*Y ). An increase in shifts the money demand curve to the right. 

The Effect of an Increase in Nominal Income (P*Y ) on the Interest Rate- An increase in nominal income  shifts the money demand curve from to which raises the equilibrium interest rate from 4 % to
7 %.

This is illustrated in Figure. If the increase in is such as to shift the money demand curve from to the result is an increase in the equilibrium level of the interest rate from 4% to 7%. A decrease in would shift to the left, and the equilibrium interest rate would fall. Remember that can change because the price level P changes or because real income Y changes (or both).

Zero Interest Rate Bound 

By the middle of 2008 the Fed had driven the short-term interest rate close to zero, and it remained at essentially zero through the middle of 2010. The Fed does this, of course, by increasing the money supply until the intersection of the money supply at the demand for money curve is at an interest rate of roughly zero. At a zero interest rate people are indifferent whether they hold non-interest-bearing money or zero interest-bearing bonds. The Fed cannot drive the interest rate lower than zero.5 A zero interest rate prevents the Fed from stimulating the economy further. If the Fed cannot lower the interest rate because the rate is at zero, there is no room for it to stimulate investment.

The Federal Reserve and Monetary Policy 

A low interest rate stimulates spending, particularly investment; a high interest rate reduces spending. By changing the interest rate, the Fed can change aggregate output (income). The Fed’s use of its power to influence events in the goods market as well as in the money market is the center of the government’s monetary policy. When the Fed moves to contract the money supply and thus raise interest rates in an effort to restrain the economy, economists call it a tight monetary policy. Conversely, when the Fed stimulates the economy by expanding the money supply and thus lower interest rates, it has an easy monetary policy.

The Term Structure of Interest Rates

The term structure of interest rates is the relationship among the interest rates offered on securities of different maturities. The 2-year rate is an average of the current 1-year rate and the expected 1-year rate a year from now, the Fed influences the 2-year rate to the extent that it influences the current 1-year rate. The same holds for 3-year rates and beyond. The current short-term rate is a means by which the Fed can influence longer-term rates.  

Types of Interest Rates 

Three-Month Treasury Bill Rate 

Government securities that mature in less than a year are called Treasury bills, or sometimes T-bills. The interest rate on 3-month Treasury bills is probably the most widely followed short-term interest rate. 

Government Bond Rate 

Government securities with terms of 1 year or more are called government bonds. There are 1-year bonds, 2-year bonds, and so on, up to 30-year bonds. Bonds of different terms have different interest rates. The relationship among the interest rates on the various maturities is the term structure of interest rates.

Federal Funds Rate 

Banks borrow not only from the Fed but also from each other. If one bank has excess reserves, it can lend some of those reserves to other banks through the federal funds market. The interest rate in this market is called the federal funds rate—the rate banks are charged to borrow reserves from other banks.

Commercial Paper Rate 

Firms have several alternatives for raising funds. They can sell stocks, issue bonds, or borrow from a bank. Large firms can also borrow directly from the public by issuing “commercial paper,” which is essentially short-term corporate IOUs that offer a designated rate of interest. The interest rate offered on commercial paper depends on the financial condition of the firm and the maturity date of the IOU.

Prime Rate 

Banks charge different interest rates to different customers depending on how risky the banks perceive the customers to be. The prime rate is a benchmark that banks often use in quoting interest rates to their customers. A very low-risk corporation might be able to borrow at (or even below) the prime rate. The prime rate depends on the cost of funds to the bank; it moves up and down with changes in the economy.

AAA Corporate Bond Rate 

Corporations finance much of their investment by selling bonds to the public. Corporate bonds are classified by various bond dealers according to their risk. Bonds  are in less risk of default than bonds issued by a new risky biotech research firm. Bonds differ from commercial paper in one important way: Bonds have a longer maturity. Bonds are graded in much the same way students are. The highest grade is AAA, the next highest AA, and so on. The interest rate on bonds rated AAA is the triple A corporate bond rate, the rate that the least risky firms pay on the bonds that they issue.

Don’t forget to subscribe for updates.

Do like, comment and share.