5.2 - Interest Rates
How commercial banks create credit and money
Commercial banks play a key role in expanding the money supply through their lending activities.
The process of credit creation by banks
- Banks create money by granting loans, which results in new deposits being added to customers' accounts.
- The borrower becomes a debtor to the bank, obligated to repay the principal plus interest.
- From the bank's perspective:
- The loan represents an asset, as it is money owed to the bank.
- The deposit created is a liability, as it is money the bank owes to the customer.
The loanable funds theory of interest rates
Interest rates arise from the interaction between those who save and those who borrow. This is explained by the loanable funds theory, which views interest as the price of borrowing money.
Key elements of the loanable funds theory
- Loanable funds refer to the pool of money available for lending in the economy.
- Interest rates are set by the supply of these funds (from savers) and the demand for them (from borrowers).
- Higher interest rates encourage more saving (increasing supply) but discourage borrowing (reducing demand).
- Equilibrium occurs where the supply and demand curves intersect, determining the market interest rate as the balanced price.
The liquidity preference theory of interest rates
The liquidity preference theory focuses on how individuals decide to hold their wealth, balancing the desire for immediate access to money against the potential returns from other assets.
Key assumptions of the liquidity preference theory
- People can hold wealth as liquid money or as illiquid assets such as bonds.
- Holding wealth as bonds means earning interest, but bond prices can change, causing wealth to fluctuate.
- The value of liquid money is stable and does not earn interest.
- High interest rates make bonds more appealing, as the interest reward outweighs the risk of price drops.
- Low interest rates make bonds less attractive, increasing the preference for holding liquid money to avoid potential losses.
Factors influencing demand for liquid money
- Expectations about future interest rates affect decisions:
- If rates are high and expected to fall, bond prices may rise, so people prefer bonds and demand less liquid money.
- If rates are low and expected to rise, bond prices may fall, leading to higher demand for liquid money to avoid losses.
- Overall, high interest rates reduce demand for money, while low rates increase it.
- The equilibrium interest rate is where the supply of money meets this demand.
Nominal and real interest rates
Interest rates can be viewed in different ways depending on whether inflation is taken into account. This distinction helps understand the true value of returns on savings.
Differences between nominal and real interest rates
- Nominal interest rates are the stated rates without adjustment for inflation.
- Real interest rates account for inflation, reflecting the actual change in purchasing power.
Formula for real interest rate
Where:
- Real interest rate = Adjusted rate showing true gain in purchasing power (%)
- Nominal interest rate = Unadjusted rate offered (%)
- Rate of inflation = Annual rise in price levels (%)
Worked example - Calculating real interest rate
A savings account offers a nominal interest rate of 6%. If the inflation rate is 2.5%, calculate the real interest rate.
Step 1: Identify the values
- Nominal interest rate = 6%
- Rate of inflation = 2.5%
Step 2: Apply the formula
The real interest rate is 3.5%, meaning the purchasing power of the savings increases by this amount after accounting for inflation.