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Interest Rates: An Introduction

Language:  English
Interest rates are critically important prices in an economy, and they are to a significant extent controlled by the central bank, reflecting monetary policy.
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The interest rate is the chief target of monetary policy, and central banks have the ability to control short-term interest rates to the extent of almost 100%. Longer-term interest rates are anchored in short-term rates. The principal interest rate targeted is the banks’ prime lending rate (PR) (which is a benchmark rate, ie all bank lending rates are referenced on PR). Why? Because new bank lending is the counterpart of money creation, and bank lending / money creation is a reflection of nominal GDP growth (government, companies and individuals borrow to undertake additional expenditure / investment). The purpose on monetary policy is to influence, via PR, the borrowers’ borrowing behaviour – the demand for credit. How do central banks control PR? They do so by setting their own lending rate to the banks, the policy interest rate (PIR), and by forcing the banks to borrow from the central bank at the PIR – or threatening to force the banks to borrow from it at the PIR. The PIR heavily influences market interest rates and ultimately the PR, and therefore the demand for credit.

  1. What are interest rates?
    1. Learning outcomes
    2. Introduction
    3. Financial system: a synopsis
    4. Debt and deposits
    5. The bank margin
    6. Rate of interest
    7. Time value of money
    8. TMV and compound interest
    9. Effective rate
    10. Coupon rate
    11. Price of a security: the principle
    12. Price of a security: multiple future cash flows and yield to maturity
    13. Other issues and terminology related to interest rates
    14. References
  2. Relationship of interest rates
    1. Learning outcomes
    2. Introduction
    3. Relationship between the policy interest rate and the banks’ prime lending rate
    4. The many, but related, interest rates on debt and deposits
    5. Interbank market interest rates
    6. Relationship of money market interest rates
    7. References
  3. Composition of interest rates
    1. Learning outcomes
    2. Introduction
    3. The yield curve
    4. Literature on the composition of interest rates
    5. Composition of interest rates: an alternative analysis
    6. Literature on the risk-free rate
    7. The risk-free rate: an alternative view
    8. Relationship of interest rates revisited
    9. References
  4. Interest rate discovery
    1. Learning outcomes
    2. Introduction
    3. Interest rate discovery and security valuation
    4. Organisational structure of financial markets
    5. Role of secondary markets
    6. Interest rate discovery in the debt and deposit markets
    7. Factors which impact on price discovery
    8. References
  5. Bank liquidity & interest rate discovery
    1. Learning outcomes
    2. Introduction
    3. Monetary policy models
    4. A bank liquidity analysis
    5. Quantitative easing
    6. Quantitative easing and interest rates
    7. Appendix 1: quantitative easing literature review
    8. References
  6. Role of interest rates
    1. Learning outcomes
    2. Introduction
    3. Primary tool of monetary policy
    4. Part of bridge between present and future consumption
    5. Advancing consumption / investment with debt
    6. Inverse relationship with asset prices and the wealth effect
    7. Interest rates and derivative instrument pricing
    8. Interest rates and the foreign sector
    9. References
  7. An optimal rate of interest: the natural rate
    1. Learning outcomes
    2. Introduction
    3. The Wicksell hypothesis
    4. Literature review
    5. An alternative interpretation
    6. Reconciliation of PR and PIR / IBMR
    7. Taylor rule
    8. A proposed Taylor-type rule
    9. References
About the Author

Prof. Dr AP Faure