Money Demand, the Equilibrium Interest Rate, and Monetary Policy
(Part D)
by
Charles Lamson
The Various Interest Rates in the U.S. Economy
Although there are many different interest rates in the economy, they tend to move up or down with one another. Here, we discuss some of their differences. We will discuss the relationship between interest rates on securities with different maturities, or terms. We then discuss briefly some of the main interest rates in the U.S. economy. The Term Structure of Interest Rates The term structure of interest rates is the relationship between the interest rates offered on securities of different maturities. The key here is understanding things like: How are these different rates related? Does a 2-year security (an IOU that promises to repay principal, plus interest, after two years) pay a lower annual rate than a 1-year security (an IOU to be repaid, with interest, after 1 year)? What happens to the rate of interest offered on 1-years securities if the rate of interest on 2-year securities increases? Assume you want to invest some money for two years and at the end of the two years you want it back. Assume you want to buy government securities. For this analysis, we restrict your choices to two: (1) you can buy a 2-year security today and hold it for 2 years, at which time you cash it in (we will assume that the interest rate on the 2-year security is 9 percent per year), or (2) you can buy a 1-year security today. At the end of 1 year, you must cash this security in; you can then buy another 1-year security. At the end of the second year, you will cash in the second security. Assume the interest rate on the first 1-year security is 8 percent.  Which would you prefer? Currently, you do not have enough data to answer this question. To consider choice (2) sensibly, you need to know the interest rate on the 1-year security that you intend to buy in the second year. This rate will not be known until the second year. All you know now is the rate on the 2-year security and the rate on the current 1-year security. To decide what to do, you must form an expectation of the rate on the 1-year security a year from now. If you expect the 1-year rate (8 percent) to remain the same in the second year, you should buy the second 2-year security. You would earn 9 percent per year on the 2-year security but only 8 percent per year on the two 1-year securities. If you expect the 1-year rate to rise to 12 percent a year from now you should make the second choice. You would earn 8 percent in the first year, and you expect to earn 12 percent in the second year. The expected rate of return over the two years is about 10 percent, it would not matter very much which of the two choices you made. The rate of return over the 2-year period would be roughly 9 percent for both choices. We now alter the focus of our discussion to get to the topic we are really interested in---how the 2-year rate is determined. Assume the 1-year rate has been set by the Fed and it is 8 percent. Also assume that people expect the 1-year rate a year from now to be 10 percent. What is the 2-year rate? According to a theory called the expectations theory of the term structure of interest rates, the 2-year rate is equal to the average of the current 1-year rate and the 1-year rate expected a year from now. In this example, the 2-year rate would be 9 percent (the average of 8 percent and 10 percent). If the 2-year rate were lower than the average of the two 1-year rates, people would not be indifferent as to which security they held. They would want to hold only the short-term, 1-year securities. To find a buyer for a 2-year security, the seller would be forced to increase the interest rate on the 2-year security until it is equal to the average of the current 1-year rate and the expected 1-year rate for the next year. The interest rate on the 2-year security will continue to rise until people are once again indifferent between one 2-year security and two 1-year securities. Let us now return to Fed behavior. We know the Fed can affect the short-term interest rate by changing the money supply, but does it also affect long-term interest rates? The answer is "somewhat." Because the 2-year rate is an average of the current 1-year rate and the expected 1-year rate a year from now, the Fed influences the 2-year rate to the extent that it influences the current 1-year rate. The same holds for 3-year rates and beyond. The current short-term rate is a means by which the Fed can influence longer-term rates.  In addition, Fed behavior may directly affect people's expectations of the future short-term rates, which will then affect long-term rates. If the chair of the Fed testifies before Congress that raising short-term interest rates is under consideration, people's expectations of higher future short-term interest rates are likely to increase. These expectations will then be reflected in current long-term interest rates. Types of Interest Rates The following are some widely-followed interest rates in the United States. Three-Month Treasury Bill Rate Government securities that mature in less than a year are called Treasury bills, or sometimes T-bills. The interest rate on 3-month treasury bills is probably the most widely followed short-term interest rate. Government Bond Rate Government securities with terms of one year or more are called government bonds. There are 1-year bonds, 2-year bonds, and so on up to 30-year bonds. Bonds of different terms have different interest rates. The relationship among the interest rates on the various maturities is the term of interest rates that we discussed in the first part of this post. Federal Funds Rate Banks borrow not only from the Fed but also from each other. If one bank has excess reserves, it can lend some of those reserves to other banks through the federal funds market. The interest rate in this market is called the federal funds rate---the rate banks are changed to borrow reserves from other banks.  The federal funds market is really a desk in New York City. From all over the country, banks with excess reserves to lend and banks in need of reserves call the desk and negotiate a rate of interest. Account balances with the Fed are changed for the period of the loan without any physical movement of money. The borrowing and lending, which takes place near the close of each working day, is generally for one day ("overnight"), so the federal funds rate is a one-day rate. It is the rate that the Fed has the most effect on through its open market operations. Commercial Paper Rate Firms have several alternatives for raising funds. They can sell stocks, issue bonds, or borrow from a bank. Large firms can also borrow directly from the public by issuing "commercial paper," which are essentially short-term corporate IOUs that offer a designated rate of interest. The interest rate offered on commercial paper depends on the financial condition of the firm and the maturity date of the IOU. Prime Rate Banks charge different interest rates to different customers depending on how risky the bank's perceive the customers to be. You would expect to pay a higher interest rate for a car loan than General Motors would pay for a $1,000,000 loan to finance investment. Also, you would pay more interest for an unsecured, "personal" loan, than for one that was secured by some asset, such as a house or a car, to be used as collateral.  The prime rate is a benchmark that banks often use in quoting interest rates to their customers. A very low-risk corporation might be able to borrow at (or even below) the prime rate. A less well-known firm might be quoted a rate of "prime plus three-fourths," which means that if the prime rate is say, 10 percent, the firm would have to pay interest of 10.75 percent. The prime rate depends on the cost of funds to the bank; it moves up and down with changes in the economy. AAA Corporate Bond Rate Corporations finance much of their investments by selling bonds to the public. Corporate bonds are classified by various bond dealers according to their risk. Bonds issued by General Motors are in less risk of default than bonds issued by a new risky biotech research firm. Bonds differ from commercial paper in one important way: bonds have a longer maturity. Bonds are graded thus: The highest grade is AAA, the next highest AA, and so on. The interest rate on bonds rated AAA is the triple A corporate bond rate, the rate that the least risky firms pay on bonds that they issue.  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 511-513* end |
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