Interest rates are a tool for Federal Bank (Fed) to control the money supply in the economy. In other words, interest rate is the rate at which the Fed lends to commercial banks. When there is an increase in demand for loanable fund, and increased interest rate will ensure that, all who demand funds will have to borrow at a higher rate.
This automatically increases the cost of borrowing for commercial banks. This induces commercial banks to increase their lending rates on loans in order to sustain profitability. An increase in loan interest rates will reduce demand for loans from the market as they become dearer, and hence, reduce the supply of money in the economy.
On the other hand, the Fed can act in the opposite direction when the money supply has to be increased in the economy. A reduction of the interest rates will make loans cheaper to commercial banks, and hence to the market. However, the banks can lower their interest rates, only to a feasible limit. The level to which the interest rates can be lowered depends on the prevailing conditions in the credit market.
Even though it is believed that interest rates are usually market determined, the Fed has a strong role in influencing the interest rate. Whenever the Fed has to ease the monetary policy through open market operations, it reduces interest rates, thus increasing the bank reserves. This will provide more money in the hand of the commercial banks that would want to increase the loans that they give out. In order to do so, they will reduce their interest rates, so that loans become more attractive and cheaper to the private loan takers. This will increase the availability of the money in the economy.
The prime rate of interest demonstrates the conservative side of commercial banks, universally known as low risk takers. They lend money to even their best customers at a minimum rate, which is called the prime interest rate.
In case of bond market, a rise in interest rate is an indicator to the market that it will fall in future. Thus, as interest rates fall, the bond prices will rise, and hence the bondholders will enjoy capital gains. Thus, by selling or buying bonds at such a time will be profitable venture for the bondholders. However, in the long term the preference for volatility in the bond market subsides considerably, and hence, there is little influence of short-term change in interest rate. Hence, the long-term interest rates in bond market much lower than the short-term interest rates.
This chapter enumerates about the economy and coordinate the kinds of goods and services produced in the country in order to show the total income and production within the geographical boundaries of the country. The kind of goods and services produced and the sufficient money circulates in the market to facilitate these outputs to be purchased and sold.
Thus, the money supply and output demand and supply should be properly synchronised through proper planning by the government. This forms the macro economic coordination process, which takes place using three variables – gross domestic product (GDP), aggregate planned expenditure (APE), and aggregate supply of funding (ASF).
GDP is defined as the volume of all goods and services produced in a country in a given year. GDP is a measure for output of the country. GDP in other terms may be calculated as the current value of all out produced in the country divided by the current year’s price index. Thus, from the definition it can be intuitively understood that there is no direct linkage between interest rates and the level of GDP.
However, this does not ensure that an increase in interest rate will not affect GDP. Thus, there may be an indirect effect of interest rate fluctuation on GDP. The incomes that are added to form the GDP adding up the wages, salaries, interest rates, depreciation, profits, taxes, net export etc. however, there is a distinct difference between GDP and GDI (gross domestic income). The former is measures from the production point of view and the latter from income, however, their magnitude may sum up to be almost same.
APE represents the demand arising from all the sectors within the economy for goods and services forming a portion of the nation’s output. APE considers only the demand in domestic output while the GDP considers production pertaining to the whole country. Thus, APE may be defined as summation of all consumption, investment, government expenditures, and export minus imports to a country. APE is indirectly related to the level of interest rising when the interest rate falls and vice versa. However, the degree of change in APE with change in interest rate is marginal.
ASF is defined as all paper money issued by the Fed, all currency available in banks and Fed, and the US Treasury plus checking account money. The ASF is therefore, the upper limit to the volume of purchases of current domestic output that is imposed on the money supply, velocity of money, and price. Thus, with increase in money supply and velocity of money, ASF also increases. ADF always equals the larger of APE and GDP.
This chapter presents a graphical presentation of GDP and APE. Graphically when GDP is represented, it is shown as a vertical line showing the current level of GDP. The graph for GDP is shown as a vertical line as this it has been mentioned in chapter 7 that there is little impact of interest rate on GDP. APE to the graph APE is measured by the equation given below:
APE = a +b(GDY) – ci , where, a is a constant that determines the influence of all the other determinants of GDY on APE, b is the rate at which an additional GDY will increase APE, and c is the responsiveness of APE to change with change in interest rate i.
When all the combinations of interest rate i and GDP are combined, we receive the IS line that demonstrates the change in GDP with change in interest rates. As the equation had previously demonstrated, APE and i has a negative relationship thus, graphically we receive a downward sloping IS curve.
ASF has been found to be a product of existing money supply and velocity of money divided by price level. For simplicity in graphical representation, the complex ASF equation is changed into a linear form. Thus, ADF as a positive relation with i. thus combining all the points, which gives the interest, rates at which presents the line equal to the APE and GDP.
This chapter presents the dynamic cost structure of the microeconomic environment that would help explain the changes in the business behaviour in the macro level. The chapter begins with a few assumptions pertaining to the micro level study of a firm. The first assumption is related to the downward sloping demand curve that firms face.
The barrier to entry and exit are not too high, thus allowing firms the opportunity to enter or leave business quickly. The profits the firms earn are not too high, so as not to attract new firms into the industry. Each of the firms face a U-shaped average cost curve indicating at very low output levels the cost of production is high. However, as the output increase, average cost declines and reaches the minimum, however, beyond that output level the average cost increase with increase in production. Firms seek to maximise profit under the prevailing demand supply condition of the market.
The marginal cost of the firm (MC) represents the increase in cost per unit increase in output. The MC curve is an upward sloping curve that cuts the AC curve from the bottom. The average revenue (AR) curve is the downward sloping curve, which represents the revenue per unit of output. Marginal revenue (MR) shows the rate of increase of revenue with a unit increase in output.
When a firm’s goal is to maximize profit, the firm will aim to equate its MR and MC. When MR is greater than MC, it implies that there exists excess demand in the market and therefore with every increase in output, profit will increase and when MC is greater than MR, it will decline in profit with every unit increase in output. The profit that is earned at the level of profit maximisation is called the economic profit. The chapter then moves on to demonstrate the changes in AR and AC would create on the profit earned by the firm and to the overall profit-maximizing goal of the firm.
The demand supply mechanism of the microeconomics can also be found applicable in macroeconomic theory. This is what can be observed in chapter 10. Whenever, ADF and ASF are found to be unequal, the market conditions will change such, that the gap between the two will tend to reduce, thus converging the economy to the equilibrium position. This is called funding adjustment in the money market. Similar adjustments occurring to converge the gap between GDP and APE are called output-price adjustment. Whenever, the gap between ADF and ASF increases, with larger ADF, there will a gap between expectations and supply.
Hence, there will be demand for greater amount of money in the market. As ADF>ASF, the demand will exceed the supply for money, thus, increasing the interest rate of money. Thus, with increase in interest rates, borrowing money will become dearer. With increased interest, banks offer more money for lending, however, there are less takers of loans as they have become dearer with increased interest rates.
Velocity of money increases due to more non-bank lending. It has been observed that inequality in the ADF and ASF induces reaction from both households and institutions to increase or decrease their funding in order to compensate for insufficient or excessive money supply in the economy. Thus, this reaction is the reason why the ADF and ASF curves move towards each other. The movement continues until they become equal.