The above diagram is a simple illustration of how the interest rate is determined. Here, the equilibrium is achieved through an interest rate of 4% and the quantity of loanable funds both demanded and supplied is equal to £1 billion. The adjustment of the interest rate to the equilibrium point occurs because if the interest rate was lower than the equilibrium level, the quantity of loanable funds supplied would be less than the quantity of loanable funds being demanded. There would then be a resulting shortage of loanable funds and this would encourage lenders to raise the interest rate they charge. On the other hand, if the interest rate was higher than the equilibrium level then the quantity of loanable funds supplied would exceed the quantity of loanable funds being demanded in the economy. As the lenders all competed to attract the small level of borrowers, the inevitable would happen and interest rates would be brought down as a result of the competition. Therefore, the interest rate approaches the equilibrium level at which the supply and demand for loanable funds exactly balance. In the economy today, the Bank of England has the task of setting the rate of interest in the six years since they were made independent in May 1997.
B) The Bank of England is the Central Bank of the UK. Since the election of the Labour government in 1997, the Bank of England has been given operational independence. This means that they set interest rates through a Monetary Policy Committee that meets monthly. Pre-1997 it was the politicians who decided the rate of interest, but now the Bank of England has taken interest rates out of the hands of politicians. The Bank of England set them at a level appropriate to meet the government’s inflation targets. The Federal Reserve in America differs in that it’s not independent and is controlled by the Government. There are some scenarios where the central bank is able to influence interest rates.
Diagram 2 shows a change in tax laws. This would encourage people to save more and would shift the supply of loanable funds to the right from S1 to S2. As a result, the equilibrium rate if interest would fall and the lower interest rate would stimulate investment. The diagram shows equilibrium interest rate falling from 7% to 6% and the amount of loanable funds increased from £1 billion to £1.2 billion.
Diagram 3 shows another scenario with influencing interest rates. If the passage of an investment tax encouraged firms to invest more then there would be an increase in the demand for loanable funds. As a result of this the equilibrium interest would rise and saving would be stimulated. Here, when the demand curve shifts from D1 to D2, the equilibrium interest rate rises from 4% to 5% and the equilibrium quantity of loanable funds saved an invested rises from £1.5 billion to £1.8 billion.
C) Demand falls when interest rates are raised through their effect on the components of aggregate demand. Aggregate demand is made up of the following types of spending: Consumption+Investment+Government Expenditure+ (Exports-Imports)
Of these, the first two in particular will be affected by interest rate changes. Consumption will fall when interest rates are raised. This happens for two reasons. The first is that it is now more expensive to borrow money. This will put people off borrowing, and lower borrowing means lower spending. However, it is not just new borrowing that is affected but also people who are still paying off existing borrowing. For many people their main investment is their house. To buy this they are quite likely to have taken out a mortgage and higher interest rates means higher mortgage repayments. These reduce their disposable income and so will leave them with less money to spend. The same will also apply to people who have borrowed to buy other things as well.
To invest, many firms will, like people have to borrow. They will borrow if they think that the rate of return on their investment is greater than interest rates. If interest rates rise then fewer investment projects are likely to be economically viable, because with the higher cost of borrowing they are now less profitable. The rise in interest rates will therefore reduce the level of investment. The amount investment falls by depends on the interest elasticity of demand for investment.
D) Monetary Policy is simply the attempt by government or a central bank to manipulate the money supply, the supply of credit, interest rates or any other monetary variables to achieve the fulfilment of policy goals such as price stability. The question is asking why banks have to lend to make monetary policy to be effective. The truth is that without loanable funds available, there would be very little economic activity and monetary policy would be ineffective. In America, the banking sector has to borrow from the Federal Reserve when it has too few reserves to meet reserve requirements that have been set. This can occur when the bank has made too many loans or because it has experienced recent expensive withdrawals. When the Federal Reserve makes such a loan to a bank, the banking sector has more reserves than it otherwise would have and these additional new reserves allow the banking sector to create more money. This is particularly useful for the central bank, as with dictating monetary policy they can influence the money supply. The Federal Reserve can alter the money supply by changing the discount rate; a higher rate discourages banks from borrowing reserves from the Federal Reserve. Therefore, an increase in the discount rate reduces the quantity of reserves in the banking system, which in turn reduces the money supply. On the other hand a lower discount rate encourages bank borrowing from the Federal Reserve, increases the quantity of reserves and as a result the money supply is increased. The Central Bank uses discount lending not only so that they are able to control the money supply but so that they can also help financial institutions when they are in trouble. So, for monetary policy to be effective the banking sector often has to be lent up to keep things running smoothly in the modern economy. An example of this is when the stock market crashed back in 1987. Many of the firms on Wall Street found themselves temporarily in need of funds to finance the high volume of stock trading. The result was that the Federal Reserve helped them out with financing “a readiness to serve as a source of liquidity to support the economic and financial system”.
So to conclude, the essay has looked at how interest rates are determined, how the central bank can influence/or set interest rates, the effect of raising interest rates and also how sometimes the banking sector is in need of help from the central bank. Monetary Policy is a huge issue which in essence controls how people spend their money; i.e. high interest rates mean people don’t wish to spend as much money. It must be said, however, that there is a difference between the central banks in America and England; the Bank of England has its independence, the Federal Reserve has been described as being the second most powerful person in America. Each has different policies and ties with their respective Governments. Consumers, Firms, Banks and Government all play their part in monetary policy and as a result of often working indirectly together the Economy is kept stable and productive.
