Economics

The Interest Rate (IR) is considered as one of the most important economic factors affecting every household, firm and government all over the world. It is, as described by Parkin et al (2005), the opportunity cost of holding money, that is, the price of borrower are willing to pay for the use of the loan. On the other hand, it is also the compensation to the risk that lenders take in lending the money. (investopedia.com, n.a. 2003) By lenders and borrowers, it refers to individuals, businesses, financial instruments and governments. IR can be also categorised into nominal IR that is the stated one on financial market and real IR that implies the return of investment in terms of value. IR is said to be an indicator of economy situation and reflection of government policy as well. Therefore fluctuations of IR would have great impact on different areas in the economy and it is crucial to understand what determines it and how it would affect the world.

This paper presents a general analysis of models of determinations s of interest rate, which are relevant to the UK economy. Thereafter, the effects of changes in IR to the economy growth will be examined. Then a conclusion will be drawn to generate the key points the paper has mentioned.

Out of all, state of economy is the fundamental parameters of IR. (Toews, 2006) when an economy experiences a growth period, IR is decreased to stimulate the amount of money circulating in the market. Conversely, IR is relatively high when a stagnation or recession occurs.

Figure 1 illustrates the relationship between real GDP which represents the economic grow and IR over 40 years in the UK. In the late 1980s the UK experiencing a huge stagnation period and from the figure the IR was high and the gap between IR and real GDP. During the late 1990s the UK economy were growing and the IR dropped. The observations reveal that a high growth will lead to low interest rate and vise versa.

Same as other commodities, there is a market for money. The money supply is the relation between quantities supplied and IR, when other influences remain the same. (Parkin et al, 2005. pp 594) Originally it is provided by central bank, in the case of the UK, Bank of England. Then other financial intermediaries like commercial banks loan money from the central bank and invest to public. In the UK, change in supply results from the change in the amount of money available to borrowers and will influence interest rate. (Heakal, 2003)

As figure 2 shows, a rise in quantity supplied shifts supply curve MS0 to MS1. In effect IR is decreased and it could be interpreted that as more funds are available now so opportunity cost of holding money is reduced. A fall in quantity supplied would cause the opposite effects.

The demand for money would also have impact on IR. (Parkin et al, 2005. pp 597) An increase in demand shifts demand curve MD0 rightwards to MD1 in figure 3, as a result IR rises. This is because as the demand is rising less money resource is available now.

Thanks to both of influences of money demand and money supply, the money market would adjust it self and eventually achieve IR equilibrium where quantity supplied equals to quantity demand as shown in figure 4. (Parkin et al, 2005. pp 596)

Inflation is an expression of the speed of losing value with respect to money, in other words, the continuously tendency of rising price level which indicates the overall economy on a large scale. (tutorials.beginners.co.uk, n.a. 2005) The higher the inflation rate is the quicker money is losing value and the more people have to pay to purchase the same products than before.

There are two main processes of inflation: demand-pull inflation and cost-push inflation. (Parkin et al, 2005. pp 655 656 657)

As figure 5 illustrated, Demand-pull inflation begins with the rightward shift of demand curve from AD0 to AD1. The price level increases and real GDP goes above potential GDP that lead to labour shortage. Then money wage rate is increased to shift supply curve from SAS0 to SAS1 and thereby bring the intercept point back on long-term supply curve while lifting the price level again.

The cost-push inflation process is similar to demand-pull inflation. Increase in cost of production induces the leftward shift of supply curve. In response, demand is stimulated by implement of new policies by, say, financial committees.

The two processes reveal how inflation influences interest rate. For example, Demand-pull inflation encourages greater government and rising IR policy would help financing funds by encouraging people to purchase bonds.

Another way of looking at the effects of inflation is to analyse the relationship between nominal, real IR and inflation rate. Fisher effect to attempted to express it as Real IR= Nominal IR -Inflation Rate. (Toews, 2006) When inflation occurs, nominal IR is increased while real IR remains the same. Figure 6 and 7 illustrate the trends of interest rate and inflation rate during recent decades in the UK and according to which there is a clear correlation between them.

Monetary policy is another determination of IR. It is an action processed by central bank to stabilize the economy by adjusting the monetary variations like quantities of money in the market. Tools of monetary policy involve repo rate and open market operation. (Parkin et al, 2005. pp 604 606)

Repo rate, which stands for rate of repurchase agreements, is the known as "the IR at which the Bank of England stands ready to make loans to commercial banks." (Parkin et al, 2005. pp 606) When Bank of England imposes a rise in the repo rate; commercial banks need pay more to borrow money. Sequentially the supply of money is reduced and IR is pushed upwards. In contrast, reduced repo rate results in decreased IR.

Open Market Operation (OMO) occurs when central bank purchase or sell government bonds in general public but not government. (Parkin et al, 2005 pp 606) It affects supply of money and eventually IR.

The influence of OMO begins on monetary base, which is the sum of central bank's liabilities held by the public and commercial banks. When Bank