Who and what determines the interest rate in the UK.

University Degree Business and Administrative studies

Introduction

On the one hand, an interest rate is the cost of borrowing money. On the other hand, it is the compensation for the service and risk of lending money. People would not be willing to lend or even save their cash, both of which require a deferment of the opportunity to forgo spending in the present, without it. However, prevailing are always changing and different types of loans will offer several interest rates. For lender, a borrower or both, It is important to understand the reasons for these changes and differences. (R.Heakal)

Moreover, the critique relating to the use of the continuance measure for the management of fixed income securities (Bierwag ,1987), which ignores any changes other than parallel ones in the term structure of interest rates, could be validly applied to the prevalent approach to measure the interest rate risk of financial institutions. In contrast, framework models the entire term structure of interest rates for a given point in time by mapping the term structure onto three main factors (Nelson and Siegel,1987). Following Diebold and Li (2006), these factors can be interpreted as slope, level, and curvature of the term structure of interest rates.

Who and what determines the interest rate

Summaries of the processes by which monetary policy is commanded are readily accessible in Budd

(1998) and in retrospect, King (1997, 2002). The Monetary Policy Committee

(MPC) of the Bank of England has the responsibility for setting interest rates is currently held. The MPC has nine members including the Governor, two Executive Directors, and two Deputy

Governors, responsible for monetary policy analysis and monetary

policy operations. Other four ‘external’ members are appointed by the Chancellor of the

Exchequer with ‘experience and knowledge, which is likely to be relevant to the committee’s functions. The purpose of monetary policy are set by the Chancellor of the Exchequer and are detailed in the

Bank of England Act 1998 as ‘(a) to maintain price stability and (b) subject to that, to support the

economic policy of the United Kingdom Government, including its objective for growth and employment’.

Money demand concerns to the demand by households, the government and businesses, for highly liquid assets such as currency and checking account deposits. Money demand is influenced by the desire to buy things in the near future, however is also influenced by the opportunity cost of holding money. The opportunity cost is the interest earnings one refuse on other assets in order to hold money. Moreover, if interest rates rise, businesses and households will likely allocate more of their asset holdings into interest bearing accounts and will hold less of cash money. Since interest bearing deposits are the main source of reserve used to lend in the financial sector, changes in total money demand influence the supply of loanable reserves and in turn affects the interest rates on loans. Money demand and money supply will be equal only at one average interest rate. Also, at this interest rate, the supply of loanable funds financial institutions wish to lend, equalizes the amount that borrowers wish to borrow. Thus, the equilibrium interest rate in the economy is that rate which equalizes money demand and money supply ( Suranovic, 2005) .

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 ...

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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»

Who and what determines the interest rate in the UK.

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