Lesson 9 - Money and Interest Rates

Money and Interest Rates
While the liquidity preference framework suggests that an increase in the

money supply will lead to the lowering of interest rates other things remaining
constant, it has been argued that in real life an increase in the money supply
might not leave everything else equal hence the behaviour of the interest rate
will be a function of all other factors including the increase in money supply.
The notion that an increase in the money supply will result in the lowering of
interest rates was criticised by Milton Friedman on this basis.
An increase in the money supply has a number of concomitant effects:

1. Income effect. Because an increasing money supply is an
expansionary influence on the economy, it should raise national
income and wealth. As we have already seen, increase in income and
wealth will lead to a rise in interest rates. It follows therefore that the
income effect of an increase in the money supply is a rise in interest
rates in response to the higher level of income.
2. Price-level effect. An increase in the money supply can also cause the
overall price level in the economy to rise. The liquidity preference
framework predicts that this will lead to a rise in interest rates. Hence,
the price-level effect from an increase in the money supply is a rise in
interest rates in response to the rise in the price level.
3. Expected-Inflation effect. The higher inflation rate that results from an
increase in the money supply also affects interest rates by affecting the
expected inflation rate. Specifically, an increase in the money supply
may lead people to expect a higher level of prices in the future; hence
the expected inflation rate will be higher. We have seen from the
loanable funds framework that an increase in expected inflation will
lead to a higher level of interest rates. The expected-inflation effect of
an increase in the money supply is a rise in interest rates in response
to the rise in the expected inflation rate.
The price-level effect and the expected-inflation effect may appear the same
but are different in that when there is a one time increase in money supply:
 Price levels will start to increase and continue to increase until
they reach a maximum at which point they stabilize. Interest
rates will increase in response to the price effect.
 While prices are increasing, expected inflation will also increase
as people expect higher levels of prices in the next period.
Because of the expected inflation, interest rates will be
increasing.
 After price levels have stabilised and are not increasing any
more expected inflation will become zero since people will no
longer expect price levels to increase as a result any rise in
interest rates as a result of the earlier rise in expected inflation
will be reversed.
It is apparent from the foregoing that price level effect will persist even
after prices have stopped increasing. On the other hand, expected
inflation effect will only persist as long as price levels continue to rise
and reverse after prices have stopped increasing.
Having demonstrated that there are many factors that can affect the
direction of interest rates most of which arise from an increase in the
money supply, most recent research has shown that increased money
growth temporarily lowers short-term interest rates.
Risk and Term structure of Interest Rates

In our supply and demand analysis of interest rate behaviour we
examined the determination of just one interest rate. However, there
are many bonds on which the interest rates can and do differ. It is
important for us to see why interest rates for different bonds differ as
such an understanding can aid in making investment decisions.
Studies of the movements of yields to maturity of bonds have shown

that interest rates on different categories of bonds differ from one
another in any given year, and the difference between the interest rates
varies over time. There are a number of factors that contribute to such
differences.
Default Risk
The risk of default i.e. the risk that the borrower may be unable or
unwilling to make interest payments when due or repay the face value
of the bond on maturity is one attribute of the bond that influences its
interest rate. Usually government bonds are considered to have a very
low default risk and are often referred to as default-free bonds.
Corporations can go into liquidation if the make huge losses or are
overcommitted with debts etc. Bonds issued by corporations are thus
viewed as more risky than government bonds. Rationally, people will
require a higher return on bonds that have higher default risk then on
bonds which have lower default risk. The difference between interest
rate on bonds with higher default risk and default free bonds is called
risk premium. The greater the riskiness of a bond the greater will be
the risk premium and thus the higher the interest rate required on the
bond.
Liquidity
Liquidity is another attribute of a bond which determines its interest
rate. The larger the market for a bond i.e. the more it is traded the more
liquid it is and it becomes a more desirable asset. Government bonds
very widely traded and are thus more liquid than corporation bonds.
Corporation bonds are not as liquid because fewer bonds for any one
corporation are traded. Prices of less liquid bonds fall and their interest
rates rise while the price of more liquid bonds rise and their interest
rates fall.
Income tax
Some bonds may be exempted from income tax. Such exemption will
mean that the return on such bonds will be higher relative to other
bonds. The bond will thus be more desirable and its demand will
increase. The increase in the demand for the bond will cause its price
to increase and its interest rate to fall.
Term to maturity
Another factor that influences the interest rate on a bond is its yield to
maturity. Bonds with identical risk, liquidity and tax characteristics may
have different interest rates because the time remaining to maturity is
different. Although interest on bonds with different maturity may be
different, empirical evidence has shown that they tend to move
together over time.
A plot of the yields on bonds with differing terms to maturity but the
same risk, liquidity, and tax considerations is called a yield curve, and
it describes the term structure of interest rates for a particular kind of
bonds. Yield curves can be classified as upward-sloping, flat, and
downward-sloping.
When yield curves slope upwards, the long-term interest rates are
above the short-term interest rates; when yield curves are flat, short-
term and long-term interest rates are the same; and when yield curves
are downward-sloping, long-term interest rates are below short-term
interest rates. Yield curves can also have more complicated shapes in
which they first slope up and then down, or vice versa.
Empirical evidence has shown that:

1. Interest rates on bonds with different maturities move together
over time
2. When short-term interest rates are low, yield curves are more
likely to have an upward slope; when short-term interest rates
are high, yield curves are more likely to slope downwards and
be inverted
3. Yield curves almost always slope upwards.
Reading assignment
1. The expectation theory
2. The segmented markets theory
The liquidity premium theory

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Money and Interest Rates

While the liquidity preference framework suggests that an increase in the

An increase in the money supply has a number of concomitant effects:

Risk and Term structure of Interest Rates

Studies of the movements of yields to maturity of bonds have shown

Empirical evidence has shown that:

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