Interest Rate Determination and Monetary Policy

Introduction:

Central Bank’s control over the money supply is monetary policy

Central Bank can alter money supply by:

• Monetary Base (Currency in circulation + cash reserves of banks)
• Interest rates (i/r)
• Exchange rates

Choice of instrument: depends on nature of economy

• United States chooses i/r (C + I important in AD)
• Singapore chooses exchange rates (more effective in maintaining px stability)

Determination of i/r:

To borrower, i/r is cost of borrowing

To lender, i/r is reward for giving the loan (& parting with liquidity)

Nominal i/r: Rate charged by lender

Real i/r: nominal i/r minus rate of inflation

Keynesian Liquidity Preference Theory:

Demand for money: The desire to hold cash balances & demand deposits as part of wealth portfolio instead of bonds

Liquidity Preference: The desire to hold non-interest bearing cash balances as part of wealth portfolio instead of interest bearing bonds and shares

Transactions Motive:

• Money is convenient medium of exchange
• Cash is held to meet planned daily expenses

Precautionary Motive:

• Cash is held to meet unplanned expenses

Demand for active balances (L_A):

• = Transactions balance + Precautionary balance
• Perfectly interest-inelastic

Speculative Motive:

• Money is held to speculate in financial assets (e.g. Bonds & Shares)
• Opportunity cost of holding money: Interest forgone
• Idle balances (L_S) is interest elastic

Liquidity Preference (LP) Curve:

• The total demand for money (M_d)
• Horizontal summation of L_A & L_S

Determinants:

• Level of income (Y)
  • Increase real Y raises demand for transactions and precautionary balances
• Frequency of income received
  • Decrease in frequency raises M_d
• px of goods & services
  • Higher px level raises M_d
• Expectations on px of goods & services
  • Expect px increase raises transactions balance to spend now and avoid high px later
• Credit facilities
  • Proliferation enables reduced cash balances

Equilibrium i/r:

Intersection between M_s and M_d

X-axis: Qty of Money

Y-axis: i/r

Money Supply (M_s):

• Stock of money available in the economy held by households and firms in the economy at a given point in time

• Determined primarily by Central Bank
• Perfectly interest-inelastic

Changes in Equilibrium i/r:

• Shift in M_d
• Change in i/r when M_s changes (movement along M_d)

Liquidity trap:

Rate of interest at lowest possible (R_L)

Increase M_s would not lead to i/r fall

No additional expenditure generated

Loanable funds theory:

Based on total demand for and supply of funds available for lending

Demand for Loanable funds (D_LF):

• Amount that households, firms and the government are willing to borrow at each i/r
  • Households willing to borrow for current consumption when current income is lower than expected average lifetime income
  • Firms willing to borrow to buy new capital goods when they believe they will eventually obtain a positive net return
  • Government borrows for development expenditure

• Varies inversely with i/r
• Factors affecting D_LF:
  • Profitability of investment opportunity: More opportunities, D_LF shifts right
  • Expectation regarding future px: Expect px rise, D_LF shifts right

Supply of Loanable Funds (S_LF):

• Supplied by current & past savings
• Varies positively with i/r
• i/r rise induces people to save
• Factors affecting S_LF:
  • Wealth: Growing wealth increases S_LF
  • Expected i/r: Higher future i/r decreases S_LF
  • Change in thriftiness: Increase shifts SLF right

Equilibrium i/r determined by interaction between D_LF & S_LF

Difference between LP theory and LF theory:

LP theory focuses on monetary factors whereas LF theory is centred on real factors (demand for physical capital and goods and services)

Monetary Policy (MP):

Supervised and implemented by Ministry of Finance & Monetary Authority of Singapore (MAS)

Tools (regulate M_s):

• Control demand of credit through i/r
  • Change Central Bank lending rate (rate at which reserves are loaned to commercial banks)
  • Rise in rate dampens demand for bank credit (contractionary effect)
• Control supply of credit by controlling credit creating ability of commercial banks
  • Open Market Operations (OMO): Purchase / sale of government bonds
  • Influence banks’ ability to create deposit by altering their holding of reserve assets
  • Sell bonds to decrease M_s
  • Banks’ liquidity ratio (ratio of liquid assets to total deposits), increase ratio to decrease M_s

Contemporary approach:

Announce i/r then conduct OMO to ensure M_s adjusted to make target i/r

Expansionary MP:

• Increase M_s to reduce i/r
• Encourage C + I
• AD rises, cyclical unemployment falls

Contractionary MP:

• Reduce M_s to increase i/r
• Discourage C + I
• AD falls, GPL falls
• Demand-pull inflation reduced

Effectiveness of MP:

Responsiveness of M_d to i/r

• If i/r-inelastic (people hold money not for speculative motive), small increase in M_s causes large fall in i/r

Responsiveness of C + I to i/r

• If i/r elastic, small fall in i/r leads to large increase
• If level of confidence is low, large fall in i/r has little impact
• If irrational exuberance occurs, large increase in i/r has little impact

Size of multiplier (‘k’)

• Smaller ‘k’ requires larger injection / withdrawal to produce same effect

Limitations of Monetary tools:

• OMO only effective if bond market is viable & broad-based
  • Otherwise, fluctuation in px of government bonds will result, hampering borrowing operations
• Change in Central Bank rate ineffective if banks are holding large amounts of liquid assets
• MP ineffective if Central Bank has small degree of control only

Singapore MP:

Exchange rate centred

• Small, open economy
  • Stable exchange rate needed to keep out import-px push inflation, maintain reasonable cost of living, low cost of production, instill confidence in the economy
  • Small deviation from foreign i/r would lead to large and quick capital movement
• Inactive secondary bond market
  • Lacks the culture of trading bonds in secondary bond market

Features of exchange rate policy:

• S$ managed using basket of currencies
• S$ operates in managed float regime
• Exchange rate band reviewed periodically
• Relinquished control over i/r and M_s

Objectives:

• Combat inflation through policy of gradual appreciation
• Combat recession through policy of depreciation (ML condition must be satisfied)

Marshall-Lerner (ML) condition: Sum of Price Elasticity of Demand of imports and exports must be > 1

Limitations:

• Depreciation may not significantly increase export volume if px inelastic / domestic Y in export market falling
• Transmission lag (J curve) may result in temporary worsening of balance of trade
• Large foreign reserve needs to be maintained, sacrificing potential economic growth (but Government Investment Corporation ensures healthy return on foreign reserve investment)
• Imperfect knowledge (though MAS practices constant vigilance in conducting MP)