Determinant of Interest Rates

The Determinants

of Interest Rates

Introduction

Interest can be defined as the price a borrower has to pay to enjoy the use of cash which he or she does not own, and the return a lender enjoys for deferring consumption or parting with liquidity (Bannock, Baxter, Davis). The many views on interest rates can be divided into two classes: real and monetary (Oscar 3). The real rate of interest is determined by the supply of and demand for real savings, whereas the monetary rate of interest is determined by the demand for and supply of money (Greenwald). However, there are many other methods that interest rate can be determined by.

Monetary Policy

A major determinant of interest rates is the central banks in the United States. Government analysts create policies that assist in ensuring stable prices and liquidity. This, in turn, ensures that the supply of money is neither too large nor too small. Suppose the monetary policy makers desire to decrease the money supply. The first step they will initiate is increasing the interest rates, which makes depositing money more incentivizing and make borrowing money from central banks less attractive. However, if banks want to increase the money supply, they would want to decrease interest rates. Therefore, borrowing and spending money becomes much more attractive (Mosler).

Term Structure of Interest Rates

Just as a relatively high price of a particular good tends to bring a good amount of physical resources into its production, a relatively high interest rate on a particular type of security tends to draw funds into the activities that type of security is issued to finance. (Russell 36).

A significant factor that can differentiate interest rates between securities is the term, or length of time before maturity, of the securities. The relationship between the terms and the interest rates is known as the term structure of interest rates. Also known as the yield curve, there are numerous reasons why analysts and...