Tuesday, April 2, 2019

Determining Rates of Interest in the Money Market

Determining Rates of Interest in the Money MarketExplain in detail how occupy rank atomic number 18 determined in the notes market. Examine the likely consequences for the macro frugality of a drop-off in the site of by-line and bring out the performers that might bushel the final results.This essay is going to demonst crop how the tell of divert is determined in the capital market. It ordain examine the cushion that a reduction in the elicit site has on the economy. The framework utilize will be the take ordinate mechanism, where an growing in the specie add will deviate interest grade and stimulate interest-sensitive expenditures. It will then highlight the factors that brush aside limit and actuate the effects of a reduction in the interest esteem.The interest rate is defined by Sloman et al. (2012) as the value paid for borrowing capital. Two factors that determine the interest rate is the total of funds and the pick up for bullion. The append of and study for money in the economy interact together to reach a take of equilibrium. agree to Sloman et al. (2012) the money market is a market for short-term debt instruments in which financial institutions argon active participants. condition 1 and 2 illust pass judgment the money market and the call for for money. The direct for money refers to an individuals desire to hold their riches in the form of money kind of of using it to purchase goods or financial pluss. The money require hoist is downward incline as an ontogeny in the interest rate stars to a decrease in the quantity of money requiremented. Money supply is the entire stock of silver and other liquid instruments in the economy. The money supply is set by the central argot (Bank of England) and is exogenous (does not depend on the use up for money). The money supply is fixed and is not influenced by the rate of interest. In betoken 1, the x-axis measures the money supply, the y-axis represent the rate of interest and the L curve ball represents the liquid pick curve ( postulate for money). The money supply is represented by the vertical line Ms. The intersection of the money supply and money demand curves reveals the equilibrium rate of interest and is fixed at that point where they equate. According to Keynes the intersection of the curves is purely a monetary phenomenon.John Maynard Keynes (1936) in his discussion the General Theory of Employment, Interest and Money described the demand for money through liquidity preference framework. According to this theory, the primary reasons for holding money are for actional, precautionary and speculative demands. The sum of all three demands work out up the total demand for money. According to the theory, if interest judge are high individuals demand for money (liquidity preference) is low and when interest rates are low, the demand for holding money harvests. In figure 2, the curve L1 is the transaction plus precautionary de mand for holding money. L stands for the liquidity preference and by definition the liquidity preference is the demand for holding assets in the form of money. L is the total demand for money balances and is derived by the swimming addition of curves L1 (the transactions plus precautionary demand for money) and L2 (the speculative demand for money). The gaucherie from L1 to L2 illustrates a shift in the liquidity preference (an subjoin in the demand for holding assets in the form of money).The interest rate mechanism is graphed in a three-stage process. Stage 1 illustrates the money market, where an development in the money supply from M to M (with everything else being equal) leads to a hang up in the rate of interest from r1 to r2. At stage 2, the bring back in the interest rate leads to an cast up in the level of enthronement from I1 to I2. The increase in the level of positionment translates in the third plot shown in stage 3. sink interest rates increases enthronis ation as it engenders proportionally cheaper for firms to invest and businesses to take out loans to pay greater outlay and enthronement. Stage 3 shows how a germinate in investment leads to a multiplied rise in the national income from Y1 to Y2. Stage 3 shows the Keynesian draw backals and injections function where an increase in investment has increased the level of injections J1 to J2. This unnecessary in injections over withdrawals will lead to a rise in the national income from Y1 to Y2. Interestingly, an increase in the level of income means that consumers will select more disposable income for consumption purposes (Sloman et al. 2012).Consumption is the largest component of aggregate demand and has an effect on other components of aggregate demand such(prenominal) as net exports and investment Griffiths and Wall (2007). Lower interest rates increases the level of consumption by making the opportunity cost of consumption is demoralize. This encourages greater expendi ture as borrowing through credit cards becomes cheaper. Lower interest rates makes relieve less attractive by minify an individuals incentive to save. This lower incentive to save encourages consumers to turn over rather than to hold onto money. It also reduces the income from savings and the interest rate that is delinquent on loans taken out. However, borrowing now becomes more attractive and this stimulates an increase in spending. Lower Interest rates can boost the prices of assets such as shares and houses. Higher house prices means that current home owners moldiness extend their mortgages which nurture enables them to finance higher consumption. Interestingly, the higher asset prices increases the wealthiness of households (through the wealth effect) which increases their incentive to spend as authorization will be higher. Higher asset prices means that businesses are also able to finance their investment (purchase of capital) at a lower cost. Lower interest rates also reduces the cost of interest payments on mortgages by reducing the monthly cost of mortgage payments. This increases the disposable income of householders which increases their level of spending. Moreover, lower interest rate can reduce the value of the Pound Sterling. If UK interest rates fall relative to overseas, saving money in UK becomes less attractive as higher returns can be earned in another country. This reduces the demand for the pound sterling and causes the reduction in the value. In figure 6 at stage 2, the fall in the currency is due to a decrease in the demand for the Pound Sterling in the unlike deputise market. The rise in the supply of the domestic currency from S1 to S2 leads to a fall in the demand for the currency from D1 to D2 and this causes a depreciation in the ex convince rate from er1 to er2. This fall leads to a rise in the demand for exports as UK exports become relatively cheaper and more attractive overseas. There will also be a fall in demand for i mports (as they become more expensive) and then causing an increase in the national income (which shape up increases spending).What if other factors can offset the full(a) extent of a reduction in interest rates? There exist time lags in the economy that can limit the regard of rate cuts on the level on interest-sensitive expenditures. In figure 4, the increase in the money supply lead to a multiplied effect and resulted in a rise in the national income. However, the mechanism failed to highlight how a rise in income will also lead to a rise in the transactional demand of money (L1). In this circumstance, at stage 1, L1 would shift to the adjust and so lead to a smaller fall in the interest rate than illustrated. Thus, the level of investment at stage 2 and the national income at stage 3 will not rise as frequently as shown as well. The boilers suit effect of the money supply on national income will depend on the size of each stage. Their relative sizes depend on the shapes of the liquidity preference and investment curves (as in figure 6 and 7). A large change in the interest rate will be caused if the liquidity preference is less elastic. The more interest-elastic the investment curve is, the bigger the change in investment. If the marginal propensity to withdraw is lower and therefore the curve is flatter, this will cause a bigger multiplied change in the national income than illustrated (Sloman et al. 2012).Keynesian economists stress how vaporizable stages 1 and 2 are in the interest rate mechanism. What if increase the money supply leads to no interest rate reductions? What if investment is nonresilient and cannot be influenced by changes in rates. Figure 6 illustrates an elastic liquidity preference curve. The less elastic the liquidity preference is, the bigger the change that will be caused in the interest rate. Due to its gently sloping curve, a rise in the money supply from M to M will lead to an only small fall in the interest rate. This will them limit the impact that the interest rate has on consumption, saving decisions and any(prenominal) other interest-sensitive expenditures. According to Keynesians, the demand for money (L) can be very elastic in response to changes in the interest rates and the liquidity preference curve can become relatively flat. The full effect of a rate cut can be expressage greatly by the nature of the demand curve. At r2, if individuals perceive and take care no further rate cuts, any increase in the money (from M to M) will have no impact on r. The liquidity trap is where Keynes look atd this additional money will be helpless in. within this theory, interest rates have a floor where an increase in the money supply has no further impact. The financial crisis 2008-09 was a predicament where constitution makers feared that increases in the money supply will lead to idle balances lost in the liquidity trap. The central bank used an unconventional monetary policy known as quantitative easing, where they advisedly increased the base rate via the purchase of bonds and other securities in exchange for money. This process of credit creation was used to increase bond prices and therefore reduce the interest rate and stimulate growth. Arguably, increases in the money supply will have some impact on the rate of interest as we have seen in the financial crisis where deliberate increases in the money supply lead to further increases in the interest rate and thus spending as well (Sloman et al. 2012). Figure 8 illustrates the effect on interest rates of an unstable liquidity preference curve. This figure further explains how the liquidity preference curve fluctuates due to factors such as expectations in the inflation rate and direction of the interest rate (to name a few). Therefore, due to its instability it is difficult to predict the effect on interest rates of a change in the money supply.Another factor that can influence the investment schedule are changes in inve stor confidence. An increase in investor confidence can shift the investment curve to the right and at any given interest rates, firms will want to invest more. A decrease in their confidence would shift the curve to the left. If investors believe that the economy is going to get out of recession, their confidence and level of investment will increase. If firms believe that inflation will rise and that the central bank will soon increase the interest rate, confidence and investment in the economy will be low (Sloman et al 2012). In Figure 7, a bigger change in investment will be caused if the investment curve is more interest-elastic. In the liquidity preference framework, investment demand is unresponsive to interest rate changes and that a large change in the interest rate is detrimental to affect investment. Evidence to settle this was illustrated through the impact of investor confidence. This consensus on the behaviour of investment can be argued in that the focus should be mo re on how volatile and preposterous investment is in response to confidence than its responsiveness to the interest rate. For example, in figure 9, the impact of a fall in interest rates is limited by business confidence. Initially, the reduction in the interest rate has increased investment. However, if the fall in interest rates is accompanied by an increase in business confidence by investors, the investment curve will shift from l1 to l2. On the other hand, if the fall in the interest rate is accompanied by a decrease in confidence then the investment curve will decrease and fall shift from l1 to l3. This impact is contrary to what was illustrated when the investment curve was believed to be inelastic. Therefore, expansionary monetary policy is likely to be more effective if firms have confidence in its effectiveness (Sloman et al. 2012).In the liquidity preference framework, the assumption is that an increase in the money supply leads to lower interest rates if everything else remains equal. However, in reality an increase in the money supply might impact other factors in the economy that could increase the interest rate instead of decreasing it. Two factors to highlight are the income effect and the price-level effect. The income effect describes how an increase in the money supply has an expansionary influence on the economy and this in effect raises the national income and wealth. The liquidity preference theory predicts that an increase in the national income and wealth will increase the interest rate and offset the original impact of an increase in the money supply. Another effect that can limit the impact of a reduction in interest rates is the price-level effect. In this effect, an increase in the money supply increases the general price level which also increases the interest rate.In conclusion, economics is a social science where theories are constantly examined and redrafted. In the interest rate mechanism theory, an increase in the money supp ly will lower interest rates and stimulate interest-sensitive expenditures. This stimulation will have a multiplied effect on the level consumption, business investment, mortgage payments and asset prices. However, the impact of a reduction in the interest rate on the economy is rather a complex subject to address. Many determinants moldiness be factored in for the full impact to be noticeable. Even if the overall effect of a reduction in the interest rate is quite strong, it is highly unpredictable to measure and estimate the magnitude of it. Investment is influenced by confidence and on elasticity to the interest rate. This changes the original impact of a rate cut. The nature liquidity preference curve can be highly unstable and not be impacted by any changes in the interest rate. There also other factors like the price-level, expectations and income that can impact and offset the intended purpose of an increase in the money supply.All the factors highlighted in this essay can l imit and offset the impact of a reduction in interest rates on interest-sensitive expenditures and the growth of the economy.REFERENCESKeynes, J.M. (1936), The General Theory of Employment, Interest and Money, CreateSpace Independent Publishing PlatformGriffiths, A. and Wall, S. (2007) utilize economics, 11th ed. Harlow Addison Wesley Longman.Sloman, J., Wride, A. and Garratt, D. (2012) Economics, 8th ed. Harlow Pearson Education Limited.BIBLIOGRAPHYhttp//www.bankofengland.co.uk/monetarypolicy/Pages/overview.aspxhttp//www.macrobasics.com/chapters/chapter8/lesson83/http//harbert.auburn.edu/thommsn/FINC-3700/ME7-WebChapters/WebApp04_4.pdfhttp//www.stlouisfed.org/publications/re/articles/?id=2505http//www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb120104.pdfhttps//www.creditwritedowns.com/2010/10/on-liquidity-traps-and-quantitative-easing.html

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