As it can be seen ,figure 1 and 2 shows this changes. Figure 1 illustrates the supply of money. A fall in the interest rate brings a decrease in the quantity of money supplied. A rise in the interest rate brings an increase in the quantity of money supplied.
Figure 2 illustrates the demand for money curve. A rise in the interest rate brings a decrease in the quantity of money demanded.A fall in the interest rate brings an increase in the quantity of money demanded.
Figure 1
Figure 2
Other factors
A number of other factors could affect interest rates, often indirectly by heightening or lowering risk. The service Bankrate states that any type of natural disaster, volatile government or price shock tends to raise interest rates up, because such events make lenders uncertain about the future. Steady and sustainable growth coupled with low inflation keeps interest rates steady, as well because lenders feel assured about the overall economy and abilities of borrowers to pay back money. In emerging markets, reformers, development economists and steady growth, unite to lower interest rates so that more people can have admission to credit, which ideally adds to new and growth, innovative businesses(Hummel,2011).
Nominal payments in the United Kingdom
Economists seek to build yield curves from real bonds in order to determine the term structure of real interest rates. Unfortunately, UK index-linked bonds are not pure real bonds. A perfectly indexed bond would pay a nominal coupon, which is equal to the coupon rate announced at the time of issue multiplied by the proportionate raise in the general price index between the issue date and the time of payment. UK index-linked bonds, however, pay nominal coupons equal to the coupon rate declared at the time of issue multiplied by the proportionate increase in the price index from a 'reference level' dated eight months before the bond's issue date to a date eight months previously the coupon payment is made. The same indexation lag refers to the repayment of principal. Thus nominal payments on UK index-linked bonds are left exposed against inflation occurring in the last eight months previously the payments occur (Bootle,1991).
This feature of index-linked bonds constructs technical obstructions in extracting implied real interest rates from index-linked bond prices. Observed price changes of an index-linked bond may reflect changes in inflation probabilities, even though with a sensitivity well below that of a purely nominal bond (Barr and Pesaran ,1995).
Changing in interest rate
The transmission mechanism of monetary policy means the ways in which variation in interest rates influenced the spending and savings decisions of huge number of households and massive amount of businesses throughout the economy. The effect of rate changes can be quite complicated and there are inevitable time lags between the Bank of England announcing a change in interest rates and it having an impact on output, demand and finally inflation(Jeffrey R.)
When the Bank of England changes the official interest rate it is trying to affect the overall level of expenditure in the economy. If the amount of spent money grows much more quickly than the volume of output produced, inflation is the result. In this way, changes in interest rates are used to regulate inflation. The Bank of England at which it lends to financial institutions. This interest rate then influence each of interest rates set by building societies, commercial banks and other institutions for their own borrowers and savers. It also tends to affect the price of financial assets, such as shares and bonds, and the exchange rate, which affect business and consumer demand in a variety of ways. Lowering or raising interest rates influence spending in the economy. A decrease in interest rates makes borrowing more attractive and saving less attractive, which stimulates spending. Lower interest rates can affect firms and consumers cash-flow – a fall in interest rates reduces the income from the interest payments and savings due on loans. Borrowers tend to spend more of any extra money they have than lenders, so the net effect of lower interest rates through this cash-flow channel is to encourage higher spending in total. The opposite occurs when interest rates are raised. Lower interest rates can boost the prices of assets such as houses and shares. Higher house prices enable present homeowners to extend their mortgages for finance higher consumption. Higher share prices elevate wealth of households and can increase their willingness to spend ()
Figure 3 shows how the money supply affects interest rate
Figure 3
Fluctuations
Fluctuations in interest rates do not have a invariable impact on the economy. Some industries are influenced by interest rate changes more than others are. And, some regions of the British economy are also more sensitive to a change in the direction of interest rates. The markets that are most influenced by changes in interest rates are those where demand is interest elastic in other words, market demand accounts for elastically to a change in interest rates.
Good examples of interest-sensitive industries include those directly linked to demand conditions in the housing market¸ exporters of manufactured goods, leisure services and the construction industry. In contrast, the demand for utilities and basic foods is less affected by short term fluctuations in interest rates. (Riley G.,2006)
The graph below shows the fluctuations in the demand for money according to interest rate
Conclusion
The results reported in this paper demonstrate who, what and how interest rate is determinated in the United Kingdom. This essay investigates the interest rate risk of the UK financial and non-financial corporations as measured by the sensitivities of their stock returns to changes in slope, level, and curvature of the UK term structure of interest rates. In addition, it shows a fluctuation in the interest rate and their factors that could affect economic growth.
Bibliography
- Barr, D. G. and B. Pesaran, 1995, An assessment of the relative importance of real interest rates, inflation, and term premia in determining the returns on real and nominal UK bonds, working paper no. 32 (Bank of England, London.)
- Bierwag, Gerald O. (1987): Duration Analysis: Managing Interest Rate Risk. Ballinger, Cambridge, MA.
- Bootle, R., 1991, Index linked gilts: A practical investment guide, 2nd ed. (Woodhead-Faulkner, London).
- Budd, A., 1998. The Role and Operations of the Bank of England Monetary Policy Committee. Economic Journal 108, 1783-1794.
- Calla Hummel,April 30, 2011
- Diebold, Francis X.; Ji, Lei; Li, Canlin (2006): A three-factor yield curve model: non-affine structure, systematic risk sources, and generalized duration. In: Klein, Lawrence R. (ed.): Long-Run Growth and Short-Run Stabilization: Essays in Memory of Albert Ando. Edward Elgar, Cheltenham, 240-274.Diebold, Francis X.; Li, Canlin (2006): Forecasting the term structure of government bond yields. Journal of Econometrics,130 (2), 337-364.
- Geoff Riley, Eton College, September 2006
- King, M., 1997. The Inflation Target Five Years On. Bank England Quarterly Bulletin, 434-442.
- King, M., 2002. The Monetary Policy Committee: Five Years On. Bank of England Quarterly Bulletin.
- Nelson, Charles R.; Siegel, Andrew F. (1987): Parsimonious modelling of yield curves. Journal of Business, 60, 473-489.
- Reem Heakal
-
Richard Jeffrey,
- Steven M.Suranovic, Chapter 40-1,2005 «International Finance Theory and Policy»