Interest rate is a monetary tool used to control the amount of money in circulation in the economy. As a monetary tool, interest rates are adjusted by the central bank of a country to either increase the amount of money in circulation in the economy or reduce this amount (Lasher, 2010). When interest rates are raised, bonds and other commercial papers become attractive to invest in and so people buy these derivatives, reducing the amount of money in circulation in the economy. When they are reduced, commercial papers become less attractive and so people prefer to hold their money in liquid form and thus increasing the supply in the economy. Several theories have been brought forward by various scholars to explain how these interest rates are determined. Some of these theories are; the expectations theory, the liquidity preference theory and the market segmentation theory (Lasher, 2010). We look at each of the mentioned theories in detail in the following paragraphs.
The Expectations Theory
This theory was brought forward by American economist Irvin Fisher. This theory explains the shape of the yield curve, which is a subject of debate amongst economists. The yield curve is a curve that shows the different yields earned for different lengths of time. It is expected that contracts taking a longer period of time will attract higher yield and so the yield curve is expected to be upward sloping. This theory proposes that the long term future interest rates can be determined from the short term future interest rates (“Expectations Theory of Interest Rates”).
Using the following equation: (1 + R2)2 = (1 + R1) x (1 + E(R1)) where R2 = the rate on two-year securities, R1 = the rate on one-year securities, E(R1) = the rate expected on one-year securities one year from now.
The left hand side represents what the investor is to get if he invests in a two year contract. The right hand side represents what the investor will get if he invests in the one year contracts, for two years. It is expected to be the same because of competition. Using this theory, the shape of the yield curve will be upward sloping if the future short term rates are expected to rise and vice versa (“Expectations Theory of Interest Rates”).
The liquidity preference theory
This theory was forwarded by John Maynard Keynes. This theory says that the level of interest rate will be determined at the intersection of the demand and supply curves of money. He defined interest as the reward for parting with money (“Yield Curve Basics”). This is because Keynes reasoned that one can decide to save his money just in money form, like keeping it under the pillow. The demand for money is determined by; the transaction motive, which is how much money is needed for daily transactions. The precautionary motive, which is how much liquid cash is needed to cater for unforeseen happenings, and the speculative motive which is the speculated future interest rates on bonds and securities. The supply is constant at any one time and is determined by the government (“Yield Curve Basics”). When these two curves are plotted on a graph of interest rate against quantity demanded, their point of intersection is the level of interest rate. It will change depending on how the demand and supply of money changes. To explaining the shape of the yield curve, the liquidity preference theory says that long term contracts attract a premium (“Yield Curve Basics”), on top of expected future higher rates, to compensate for the risk taken in longterm contracts. The longer the period, the higher will be the yield and so the yield curve is upward sloping.
The market segmentation theory
This theory explains that financial instruments having different time spans are not substitutable. The longterm one and the shortterm ones are not substitutable and so their interest rates are determined independently (Lasher, 2010). The investors will decide in advance where to invest. It is assumed that most investors will want to invest in the shortterm instruments thus pushing their yields down as compared to the longterm instruments (Lasher, 2010). As a result the yield curve will be upward sloping.
Interest rate is an important monetary tool. Though there are many theoriesto explain its determination, all conquer that when well applied, they shape the performance of the economy in terms of growth.
References
Expectations Theory of Interest Rates. Eagle Traders. Com. Retrieved from
http://www.eagletraders.com/advice/securities/expectations_theory_of_interest_rates.htm
Lasher, R. W (2010). Practical Financial Management, 6th Ed. Cengage Learning
Yield Curve Basics. Rethink Your Defence. Retrieved from
http://www.rethinkyourdefence.com.au/yield_curve_basics.asp?expand=1
