The

Determination of
Interest Rates
and the MPC


Overview
Candidates should understand how the demand for, and
supply of, funds in different markets affect interest rates.
Candidates should have an understanding of the factors
considered by the MPC when setting interest rates.
The Three Key Functions of Money



Medium of
Exchange
Unit of Account
Store of Value
The Money Supply 1
Money supply: the total amount of money circulating in the economy.
Cash
Sight
Deposits
Time
Deposits
Treasury
Bills
Physical
Assets
Liquidity
Narrow money: notes and coins. (M0 is cash and M4 is
physical assets). This includes the spectrum of liquidity in
the economy.
Broad money: money used for saving as well as spending.
All types of assets (M4).
The Money Supply 2
Interest Rate (%)
Money Balances
MS
MS is perfectly
inelastic as there is a
fixed stock of money in
the economy.
The Demand for Money 1
Demand for money: the amount of money that people like to hold as
cash rather than in other forms.

Three reasons for holding money:
Transactionary demand: to buy goods and services. Based around
aggregate demand.
Precautionary demand: just in case.
Speculative demand: to take advantage of investment opportunities.
Demand based on the interest rate charged, this will depend on
whether you hold cash or financial assets.
ISAs or savings accounts, the higher the interest rate, the higher the
opportunity cost of holding.
The Demand for Money 2
Interest Rate (%)
Money Balances
LP
The lower the interest rate, the more cash you will want to hold instead
of assets.
Interest rate is what you forego.
Interest Rate Determination 1
Interest rate: the cost of holding wealth as money.

The interest rate is just a price: the price of money.

An interest rate is determined in the usual microeconomic manner: by
the interaction of its supply and demand.
Interest Rate Determination 2
The Central Bank determines the
overall money supply.
Through this it can influence the
central interest rate, which then
filters through all interest rates.
The LP curve is primarily determined
by the level of income.
Bank of England raised the money
supply and reduced interest rates
which meant there was no need to
hold financial products which are
interest bearing.
Interest Rate (%)
Money Balances
LP
MS
IR*
Glorified supply and
demand diagram for
money.
Liquidity
preference.
Interest Rate Determination 3
An increase in the money
supply:
Reduces the interest rate.
Increases borrowing,
spending and investing.
Increases aggregate
demand.
Interest Rate (%)
Money Balances
LP
MS1
IR1
MS2
IR2
Interest Rate Determination 4
An increase in the level of income:
Increases the demand for money.
Increases the interest rate.
Reduces borrowing, spending and
investing.
Reduces aggregate demand.
Liquidity preference is the demand for
money which is based around interest.
Low interest equals less demand.
Banks have harder regulations now-
govt wanted to lend more but you have
to have 25% deposit instead of 5%.

Interest Rate (%)
Money Balances
LP1
MS
IR1
LP2
IR2
When there is
more demand
for money,
interest rates
are raised to
disincentivising
people to save
money.
Interest Rate Determination 5
There are countless different interest rates in the economy.
Each is determined by the demand for and supply of the
particular asset for which the interest rate applies.
Reasons why interest rates differ:
Time- The longer you hold money, the better the rate of return.
Expectations- If you keep taking money out, there is a risk for the
bank to keep money.
Risk.
Administrative costs.
Imperfect knowledge.
Bank of Englands interest rate establishes a competitive environment of
interest. Demand and supply of money is determined by risk, more risk, the
higher the rate of return. But with forward guidance, the Bank of England is
trying to counter act lack of confidence.
The Monetary Policy Committee 1
The Monetary Policy Committee 2
Interest rates are set by the Banks Monetary Policy
Committee. The MPC sets an interest rate it judges will
enable the inflation target to be met. The Bank's Monetary
Policy Committee (MPC) is made up of nine members the
Governor, the two Deputy Governors, the Bank's Chief
Economist, the Executive Director for Markets and four
external members appointed directly by the Chancellor. The
appointment of external members is designed to ensure that
the MPC benefits from thinking and expertise in addition to
that gained inside the Bank of England.
Bankofengland.co.uk
The Monetary Policy Committee 3
Factors the MPC consider when setting interest rates:
The inflation target- If there is spare capacity there will be non-
inflationary growth for a period of time which is what were in at the
moment. The higher the inflation target, the lower the interest rate.
The level (and growth rate) of aggregate demand: the output gap.
The level (and growth rate) of production costs.
Expectations.
Performance of other economies- high inflation in EU means high
inflationary pressure in the UK.
House prices- housing bubble means interest rates may have to be
raised to reduce demand.
Exchange rate trends.



What You Should Know
What is meant by money?
What is meant by the demand for money and what
affects this?
What is meant by the supply of money and what affects
this?
How do the demand for and supply of funds in different
markets affect interest rates?
What factors are considered by the MPC when setting
interest rates?
Has Quantative Easing Been
Succesful?
It did reduce the deflationary pressure.
However it didnt particularly increase consumer and business confidence
because banks held onto the money from bonds to secure themselves and
pay off the debts which they had defaulted on in the boom years.
Out of the first round of 200 billion QE only 25 billion was bought by
banks.
QE is designed to raise asset prices and thus boost spending to increase
inflationary pressure.
Significant time lag and hard to measure its success.
Gilt prices rose by 20% and yield decreased by 1% which is better than
without QE.
Inflaiton rose by between 0.75% and 1.5%.
David Smith- What shouldve been an emergency tool became an everyday
instrument.
Savers have received 70 billion less than they wouldve done without QE.
Only top 10% richest households gained by a 129,000 increase in wealth/
Liquidity Trap
Consumers and businesses have expectation of what constitutes a normal
rate interest. Their expectations of where interest rates are likely to head in
the future can affect their spending and savings behaviour.
Consider a situation where a central bank has slashed interest rates to
abnormally low levels perhaps because they fear a deep recession or to
reduce the threat of price of deflation.
When interest rates are very low, people may downgrade their forecasts for
the returns likely on investment such as property, stocks and bonds. The low
interest rates may tell them that something is badly wrong in the economy.
As a result they may choose to hoard cash or save a rising share of their
income in short-term interest bearing accounts. They key is that they think
that the next move in interest rates is likely to be upwards because interest
rates are rarely at abnormally low levels.
The expectation of interest rates moving higher may encourage them to
save even more and postpone consumption even though the central bank is
trying to stimulate spending through a low interest rate policy.
Savings rates are high at the moment, it goes against conventioanal theory
and so monetary policy is not as effective.
How to overcome the liquidity
trap.
1. In a liquidity trap, fiscal policy may become more important as an
instrument of demand management e.g. running a larger budget
deficit to boost demand through the circular flow and increase the
money supply.
2. There is also pressure on central banks to supply the financial
markets with extra liquidity to encourage them to lend to each
other again and increase the flow of funds available for borrowers
3. A rise in inflation can also help! Because higher inflation can lead
to real interest rates becoming negative and eventually
stimulating an expansion of household and corporate spending.
This is happening in the USA now.
4. The central bank may want to establish in peoples minds that
they will keep real interest rates low .
5. 2/3rds of business investment was cut during the recession.

Credit Crunches
A second reason why low interest rates may not work to
stimulate demand is when there has been a collapse in
confidence in the financial sector leading to a credit crunch. In
this situation the major financial institutions such as banks,
building societies and other lenders may decide to cut the
amount that they are (i) prepared to lend to each other and
(ii) prepared to lend to personal and corporate borrowers.
A fall in the supply of lending raises inter-bank interest rates
and creates a dis-connect between official policy interest rates
and the cost of borrowing in wholesale and retail credit
markets. We have seen some evidence of this in the UK in
recent months with the Bank of England cutting interest rates
gradually but at the same time, mortgage interest rates have
risen (and mortgage loans have become harder to get).

Liquidity Trap- Demand for money is perfectly
elastic.
Rate
of
Intere
st
Demand for
Money