Monetary Policy and Interest Rate Determination: Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Chapter 4
Monetary Policy
and Interest Rate
Determination
Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Learning Objectives

Introduction
 Interest Rate: The price that has to be paid by a borrower

of money to a lender of money in return for the use of funds
 Term Structure of Interest Rates: The yield to

maturity on Treasury bills and bonds of different terms to
maturity
 Money: The medium of exchange that facilitates

transactions in an economy

Bills
 Bills: Financial assets with less than one year until the date that they
will be redeemed by the original borrower.
 Have a highly liquid secondary market
 Highly attractive assets as they have negligible risk and high liquidity
 Sold at a discount on their face value
 Holders of bills benefit entirely from capital appreciation

Bills
 Example: If a three month $100 bill is sold at $97, the annual rate of
interest at the time of issue is:
 Example: If a three-month $100 bill is sold at $98, the annual rate of

interest at the time of the issue is:
 Inverse relationship between the price of the bills and the

short-term of interest rate

Bonds
 Longer term financial assets with a maturity of 1 to 30 years
 Issued at face value, instead of capital appreciation the holder is

entitled to a stream of coupon payments
 Can be freely traded in the secondary bond market
 Price of the bond once issued will fluctuate according to market

conditions
 Inverse relationship between the price of the bonds and

the rate of interest

Bonds
 Example: If a bond is originally issued at $100 and each

year it makes annual coupon payment of $10. It is issued at
an annual rate of interest:
 If immediately upon issue the price of the bond were to rise

in the secondary market to $120, then the coupon rate of
interest would be:

The Operation of Monetary Policy
 Most countries have a central bank.
 Responsible for the operation of monetary policy, changing the money

supply held by banks and the public, and targeting short-term interest
rates prevailing in the money markets
 There are three types of monetary policy:

 Neutral
 Contractionary
 Expansionary

Effects of Expansionary Monetary Policy
 Expansionary OMO: An open market operation that increases the

narrow money supply and lowers the short-term interest rate.
 Central bank purchases short-term financial securities (usually

Treasury bills).
 Public holds more money but fewer Treasury bills.
 Central bank has an increase in liabilities (money circulation with the

public) but also a corresponding increase in assets ( Treasury bills).
 An expansionary OMO increases the demand for bills, raises the price
of bills and hence lowers short-term interest rates.

Effects of an expansionary OMO

Effects of a Contractionary Monetary Policy
 Contractionary OMO: An open market operation that decreases the

narrow money supply and raises the short-term interest rate.
 Central banks sells newly issued Treasury bills that are issued on behalf
of the Treasury.
 Public holds less money but more Treasury bills.
 Central bank has a decrease in liabilities (money in circulation with the

public), but also a corresponding decrease in assets (Treasury bills).
 A contractionary OMO, by increasing the supply bills, lowers the price

of bills and hence raises the short-term interest rate.

The effects of a contractionary OMO

Summary of expansionary and
contractionary monetary policies

Monetary Policy in Practice and Announcement
Effect
 In the US, the Federal Reserve Open Market Committee (FOMC) meets
every four to six weeks to discuss its target for short-term interest rate.
 In the UK , the Monetary Policy Committee (MPC) meets periodically

to discuss its target short-term interest rate.
 These meetings are crucial to the implementation of monetary policy

since at the end of the meeting an announcement is made concerning
the short-term interest rate.
 The Committee will announce its target short-term rate which may be
higher or lower than the market was expecting.

Effects of Unexpected Cut in Short-Term Interest
Rate
 If an unexpected cut in interest rates is announced, the market will do the

work for the central bank without having to buy Treasury bills.
 With an announced interest rate cut, Treasury bill prices rise.
 Private agents want to hold less money but more bills in their portfolios to
make a capital appreciation from the rise in Treasury bill prices.
 Money demand shifts to the left.
 Demand for Treasury bills shifts to the right.
 The market automatically moves to the desired interest rate without an

increase in the money supply.

Effects of unexpected cut in short-term interest rate

Effects of unexpected rise in short-term interest rate
 Treasury bill prices will fall.
 Private agents want to hold fewer Treasury bills and more money in
their portfolios to avoid capital loss from the fall in Treasury bill prices.
 Money demand shifts to the right.
 Supply of Treasury bills traded increases with a shift to the right.
 The market will automatically move to the desired interest rate without
a fall in the money supply.

Effects of unexpected rise in short-term interest rate

Commercial Banking System and Narrow & Broad
Money Supply
 Narrow Money Supply (M0): Cash held by the non-bank public

and cash reserves held by the banking system.
 M0=Notes + coin + reserves of the banking system
 Broad Money Supply (M1): The narrow money supply plus sight
deposits held by the banking system.
 M1=Notes + coin + reserves of the banking system + sight deposits

Relationship between base money, bank deposits
and broad money

Money Multiplier
 The link between the monetary base and the broad money supply is given by the
money multiplier:
 Broad Money Supply = Money Multiplier*Monetary Base
 The banks’ desired ratio of cash reserve [R] to total deposits [D] is given by r:
r=R/D
The public’s desired ratio of cash in circulation [C] to banks’ deposits [D] is given by
c:
c=C/D
 The total reserves of the banking system [R] is given by the reserve ratio times the
volume of the deposits:
R=rD

Money Multiplier
 Total cash held by the public is given by the volume of deposits times the cash
holding ratio of the public:
C=cD
 The monetary base is defined as cash held by the banks plus cash held by the
non-bank public:
B=C+R=(c+r)D
 The broad money supply(M1), is currency in circulation plus banks’ demand

deposits:
M1=C+D=(c+1)D
 Money multiplier: M1=(c+1)B/(c+r)

Money Multiplier
 Example: Monetary base is £100 million
 c=0.2, r=0.1
 The money multiplier is 4
 The broad money supply is four times the narrow money supply

Controlling the Money Supply
The value of the money supply is affected by changes in either the money
multiplier or changes in the money base.
 Contractionary/expansionary open market operations
 Raising/Lowering the reserve requirement
 Raising /lowering the central bank lending rate

Determination of Interest Rates
 The rate of interest is determined in the money market by the supply of

and demand for money. Money demand has three types: Transactions
demand, speculative demand & precautionary demand.
 Transaction demand is a positive function of income
 Mt=Mt[Y]
 Mt: Transaction demand for money
 Y: Level of the national income
 Speculative demand has an inverse relationship with the rate of
interest
 Msp=Msp[r]
 Msp: Speculative Demand for Money
 r: the rate of interest

Determination of Interest Rate
 Money supply is determined exogenously by the authorities
 In equilibrium, money demand (Md), made up of transactions and

speculative balances, is equal to money supply (Ms):
 Md=Msp+Mt=Ms

Supply and Demand for Money

|Effect of Increases in Money Demand & Supply on Short-term
Interest Rate

Loanable Funds Approach to Interest Rate
Determination
This approach argues that economic agents have a certain amount of

financial wealth and they can choose to hold this wealth in the form of
either interest-earning financial assets or in money which earns no
interest, or a combination of the two.
 The Supply of Loanable Funds

The stock of loanable funds is the stock of financial assets on which
interest is paid. It is determined by three factors:
 The amount of savings
 Switches from money holdings into savings products
 An increase in loans made by financial institutions
A rise in the interest rate leads to an increase in all these factors giving an upward-sloping
supply of loanable funds.

Loanable Funds Approach to Interest Rate
Determination
The demand for loanable funds represents the demand for an increased
stock of debt, to finance present aggregate demand in the form of
consumption, investment and government expenditure on goods and
services. It is determined by three factors:
 Investment demand
 Borrowing for consumption
 Increases in money demand
A rise in the interest rate leads to a fall in all three factors, giving a downward-sloping demand
of loanable funds.
The intersection of the supply and demand for loanable funds determines the interest rate.

Demand and Supply of Loanable Funds

Effects of Increases in Demand and Supply of
Loanable Funds

Inflation and Interest Rates
 Nominal interest rate is divided into three components
 r: nominal rate of interest
 i: real rate of interest under conditions of inflation certainty
 :expected inflation rate

Inflation and Interest Rates
 Example:
 In Country A, the nominal rate of interest is 8%.

 Assume that inflation rate may vary between the three values 3%, 5% and
7%.
 The average expected inflation rate is 5%, but lenders of funds might find
that inflation is 7%, which would reduce the real return so they charge a 1%
inflation risk premium.
 If lenders are absolutely sure that the inflation rate will be 5%, there will be
no need to charge inflation risk premium, and the nominal interest rate
would be 7%.

Other factors that affect the interest rate
• Default risk
Highly rated companies with good credit ratings are able to borrow
funds at a lower interest rate than companies with poor credit ratings.
Loans to the government are considered risk-free (when the debt is
denominated in their own currency and they have the ability to print
that currency).
• Liquidity risk
The less liquid the security, the higher the interest rate
• Duration of a loan
The longer the duration, the higher the interest rate (generally
speaking but not always – see negatively sloped yield curve)

Theories of the Yield Curve
 Yield curve plots the yield to maturity of Treasury bills and

Treasury bonds with different terms to maturity issued by the
government.
 Positively-sloped yield curve: A government that wishes to

borrow for a long period pays a higher yield than for medium-term
borrowing, which in turn has a higher yield than for short-term
borrowing.
 Negatively-sloped yield curve: A government that wishes to

borrow for a long period pays a lower yield than for medium-term
borrowing, which in turn has a lower yield than for short-term
borrowing.

 Hump-shaped yield curve: A government that borrows

medium term is paying higher yields than for borrowing
short term or long term.
 Flat yield curve: All short, medium, long-term

borrowings has approximately the same yield.

Various yield curves

 Expectations theory
 Liquidity preference theory
 The preferred habitat theory
 Market segmentation theory

Expectations Theory
 Long-term interest rates are determined by market expectations about

the path of future short-term interest rates.
 Positively-sloped yield curve market participants expect that short-

term interest rates will increase in the future.
 Negatively-sloped yield curve market participants expect that short-

term interest rates will fall in the future.
 Flat yield curve indicates that market participants expect that short-
term interest rates remain fairly constant in the future.

Expectations Theory
 Long-term interest rate:
 rn Long term interest rate on a bond with maturity of n years

 r0 Current one-year interest rate
 r1 One year interest rate expected in one year’s time
 r2 One year interest rate expected in two years’ time
 Example: Interest rate on a five-year bond is the simple arithmetical

average of all future known interest rates.

Expectations Theory
 The following are the expected interest rates for the five-
year bond:
 Current one-year interest rate: 7%
 One-year interest rate expected in one year’s time: 8%
 One-year interest rate expected in two years’ time: 9%
 One-year interest rate expected in three years’ time: 10%
 One-year interest rate expected in four years’ time: 11%

Liquidity Preference Theory
 According to liquidity preference theory, the yield on long-term bonds

reflects not only market expectations but also a liquidity premium.
 Liquidity premium: The extra yield required to hold securities that are
less liquid than securities with similar risk features.
 It predicts a generally higher interest rate than the pure expectations

theory.
 The theory assumes that lenders of funds prefer to lend short, borrowers
prefer to borrow long. Borrowers are prepared to pay a liquidity premium
to lenders to induce them to lend long.
 The size of the liquidity premium increases with the time to maturity.

Preferred Habitat Theory
 Argues that the term structure reflects both expectations of the future
path of interest rates and a liquidity premium. However, liquidity
premium does not have to rise uniformly with the maturity of the bond
as assumed by the liquidity preference theory.
 Example: If both short and long-term investments are preferred

habitats, then medium-term interest rates may be higher to induce
investors to undertake medium-term investments.
 Example: If most investors have a preferred habitat of five-year

investments, the short-term and long-term interest rates may be both
higher to induce investors to accept investments at these time horizons.
Could lead to a U-shaped yield curve

Market Segmentation Theory
 This theory assumes that there are barriers to switching

between short, medium and long-term investments. These
barriers may be due to the need to meet regulatory
requirements, may be self-imposed regulations or even
transaction costs.
 The shape of the yield curve is determined by separate supply

and demand forces in each particular maturity segment.
 Changes in interest rates in a particular segment of the market

will have relatively little influence on other segments of the
market.

Monetary Policy and Interest Rate Determination: Keith Pilbeam ©: Finance and Financial Markets 4th Edition

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Chapter 4

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

 Interest Rate: The price that has to be paid by a borrower

 Term Structure of Interest Rates: The yield to

 Money: The medium of exchange that facilitates

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

 Have a highly liquid secondary market

 Sold at a discount on their face value

 Holders of bills benefit entirely from capital appreciation

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

 Example: If a three-month $100 bill is sold at $98, the annual rate of

 Inverse relationship between the price of the bills and the

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

 Longer term financial assets with a maturity of 1 to 30 years

 Issued at face value, instead of capital appreciation the holder is

 Can be freely traded in the secondary bond market

 Price of the bond once issued will fluctuate according to market

 Inverse relationship between the price of the bonds and

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

 Example: If a bond is originally issued at $100 and each

 If immediately upon issue the price of the bond were to rise

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

 Most countries have a central bank.

 Responsible for the operation of monetary policy, changing the money

 There are three types of monetary policy:

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

 Expansionary OMO: An open market operation that increases the

 Central bank purchases short-term financial securities (usually

 Public holds more money but fewer Treasury bills.

 Central bank has an increase in liabilities (money circulation with the

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

 Contractionary OMO: An open market operation that decreases the

 Public holds less money but more Treasury bills.

 Central bank has a decrease in liabilities (money in circulation with the

 A contractionary OMO, by increasing the supply bills, lowers the price

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

 In the UK , the Monetary Policy Committee (MPC) meets periodically

 These meetings are crucial to the implementation of monetary policy

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

 If an unexpected cut in interest rates is announced, the market will do the

 With an announced interest rate cut, Treasury bill prices rise.

 Money demand shifts to the left.

 Demand for Treasury bills shifts to the right.

 The market automatically moves to the desired interest rate without an

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

 Treasury bill prices will fall.

 Money demand shifts to the right.

 Supply of Treasury bills traded increases with a shift to the right.

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

 Narrow Money Supply (M0): Cash held by the non-bank public

 M0=Notes + coin + reserves of the banking system

 M1=Notes + coin + reserves of the banking system + sight deposits

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

 Broad Money Supply = Money Multiplier*Monetary Base

Keith Pilbeam ©: Finance and Financial Markets 4th Edition

 The broad money supply(M1), is currency in circulation plus banks’ demand