Interest rates and the money market

Keonomie growth is a plus. hut. like all good things, it's best not to have too much at once If the economy grows too rapidly, the result ean he inflation. Steady growth is best, and governments use fiscal and monetary policy tools to achieve this. For example, they set interest rates in order to control Ivurowing and investment. However, the government can't just state, 'today's interest rate is four per cent' and expect all the other banks to follow As usual, things are a bit more complicated!

The interest rate is not really set by the government at all. but by the levels ol'demand and supply of money in the money market. Imagine that money is like any other commodity, and the price of money is the interest rate. Hanks can charge any interest rate that customers are willing to pa\ If there is a limited amount of money available, the suppliers (the banks) will charge a higher price (the interest rate) as demand for money increases. Demand comes from the public who want to spend money to buy things and from businesses who want to invest money in order ю grow. Just like other commodities, demand for money will fall as the price (interest rate) rises. The interest rate will be set by the market. It will be where the demand and supply curves meet the equilibrium paint. Vou can see this relationship shown in figure I on page 7S

И * С ГТ» I I t 4 П 0 » i 4 « to t i « « i w i i U• 11 IS 77

Macroeconomics: the science of economic growth and stability

Also, just like other markets, there can be shifts В Comprehension

in the demand and supply curves. When shifts

Now read the text again and decide whether

happen, the equilibrium point (the interest rate

these statements are true or false. that is set) changes. This new interest rate may

be above or below the government's target. What can they do about it? One thing they can do is to 1 When the government sets interest

rates, commercial banks must set

influence the supply of money in the market.

the same rate. td/fd

What exactly is the money supply and how can

2 Interest is the price of money.

td/fd

the government influence it? Obviously, the

3 As interest rates increase, demand

money supply includes all the notes and coins in

for money falls.

td/fd

purses, pockets and cash tills. Some of this money

4 The money supply is only all

will be money that has been borrowed from

the notes and coins that are in

banks, so loans form part of the money supply

circulation.

td/fd

too. The supply also includes money that people

5 Banks lend money, but they never

and companies have in bank accounts, and the

borrow money.

td/fd

money that banks have in their reserve accounts

6 At the end of each day banks

in the central government bank.

usually have less money than

they need.

T•/F•

Remember that banks lend most of the money

that customers deposit. When customers want

to make withdrawals, the bank takes cash from

its reserve account with the central government

Before you listen

bank. If the commercial bank has a shortage of cash in its reserve account, it is obliged to borrow from the central bank. When a commercial bank borrows from the central bank, it must borrow at the government's rate of interest. This is how the government can influence the interest rate equilibrium point of the market.

However, the government needs to ensure that at the end of each day the commercial banks have a shortage of cash. And, of course, they have ways of doing this!

Figure 1: Demand and Supply in the money market

Discuss the following with your partner.

Read the summary which explains what open market operations are. Try to complete the gaps with words from the box.

Л

• borrow • decreases • lend

I reserve Ш selling В shortages (x2)

ч

T h e g o v e r n m e n t can c r e a t e

(1) of m o n e y for commercial banks by (2) securities.

Securities are a w a y to ( 3 ) m o n e y to the g o v e r n m e n t at an a g r e e d rate of interest. This is what is k n o w n as open market operations. W h e n p e o p l e b u y securities the m o n e y

supply ( 4 ) (5 ) (6 ) (Z) bank.

This causes in the c o m m e r c i a l banks' accounts, so they have to m o n e y f r o m the central

78

Macmillan

Guide

to

Economics

Demand for money

Unit IS

TС Listening H))) Now you're going to hear someone talking about open market operations. Listen and check your answers.

Before you read

Discuss these questions with your partner.

-» Economists sometimes talk about economic

shocks. What do you thmk this might mean? What might cause a shock to the economy?