Interest Rates Financial Markets and Monitory Policy

Interest Rates 12 Running Head: Interest Rates Financial Markets and Monitory Policy By (Name) (Tutor) (University) (Date) Introduction 3 Part A 4 Demand for Loanable Funds 4 On the Supply Side of Loanable Funds. 4 Government Budget Deficit 6 Justification 7 Part B 8 Recommendation and Justification 8 Part C 8 Relationship between UK and US 8 A Raise in the Level of Interest Rates by the UK in UK 9 Effect of Higher Interest Rates in the UK on the US 10

Running Head: Interest Rates
Financial Markets and Monitory Policy
By (Name)
(Tutor)
(University)
(Date)

Interest Rates 2
Table of Contents
Introduction......................................................................................................................................3
Part A...............................................................................................................................................4
Demand for Loanable Funds........................................................................................................4
On the Supply Side of Loanable Funds.......................................................................................4
Government Budget Deficit.............................................................................................................6
Justification......................................................................................................................................7
Part B...............................................................................................................................................8
Recommendation and Justification..............................................................................................8
Part C...............................................................................................................................................8
Relationship between UK and US...............................................................................................8
A Raise in the Level of Interest Rates by the UK in UK.............................................................9
Effect of Higher Interest Rates in the UK on the US.................................................................10
Justification................................................................................................................................10
Bibliography..................................................................................................................................12

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Financial Markets and Monitory Policy
Introduction
There are various factors that affect the level of interest rates in an economy. They
include the state of the economy, inflation levels, government spending and money supply in the
economy to name just but a few. When the economy is experiencing growth it means there is a
heightened economic activities in the economy. This economic boom attracts more and more
investors in the economy investing. This leads to an increased demand for funds in the loanable
funds market which leads to higher interest rates demanded by lenders to increase the money
supply. However, the relationship between interest rates and economic growth is a two-way
street as each can affect the other’s direction.
Inflation eats into earnings as it lowers the real value of earnings. With rising inflation
lenders are forced to raise interest rates to keep up with the rising inflation (Schneider, 2017).
This is because every rise in the inflation level translates into a loss in value in the sense that
with inflation the amount of goods one could have purchased with say $500 is reduced. In the
money market higher inflation tends to lower the real interest rate they thus need to revise the
rates to maintain their profitability.
The government through the Federal Reserve can also influence the level of interest rates
through manipulation of the money supply. The Federal Reserve manipulates the money market
in an effort to regulate economic growth in the country, consequently regulating unemployment
and inflation in the state. When inflation is growing rapidly and with negative effects on the
economy, the Federal Reserve in order to reduce the money supply in the economy raises the rate
at which they lend out money (Koziol, 2012). This in turn leads to higher rates charged by
borrowers from the Federal Reserve to the households and businesses. This higher interest rate
deters more borrowing thus reduced money supply.
In this case however, economic growth being stagnant, inflation being expected to remain
constant, the level of saving not changing and the Federal Reserve not expected to change the
existing supply of loanable funds they are thus non factors. Therefore we shall stress on reduced
government spending and the effect of a foreign interest rate change in determining the level of
interest rates in the US economy.

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Part A
Demand for Loanable Funds
Lower interest rates encourage consumers to borrow more to finance their purchase of
durable commodities such as televisions. Lower interest rates also entice firms to acquire and
hold more capital. This is because the capital is now acquired cheaply and the projected income
from that acquisition remains unchanged thus a higher NPV as compared to if the acquisition is
made at a higher interest rate. Therefore, the lower the interest rates, the greater the demand for
loanable funds. The reverse is also true. As a result, the demand for loanable funds curve is
downward sloping as illustrated below.
Fig: Demand for loanable funds
Interest Rate
ii
I0
DLF
qi q0 Quantity of Loanable funds
On the Supply Side of Loanable Funds.
The main tool used by the Federal Reserve to manipulate interest rate is through the
setting of the target federal funds rate. Banks are required to keep a certain amount of capital and
deposit with the Federal Reserve Bank known as federal funds. The federal funds vary
depending on the banks outstanding loans and deposit.it is acceptable for banks with excess
reserves to loan those that run short. The rate at which these loans are made out depends on the
current target federal funds rate. This funds rate forms the base upon which interest rates are

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determined as it is passed through to businesses and consumer loans. (Americanexpress.com,
2018)
Higher interest rates act as an incentive to consumers to forego some of their
consumption in order to save more (due to the higher returns earned on their saving). Companies
in turn prefer not to invest in capital goods as the higher rates work against them to lower the
NVP on their capital projects. Instead they hold on to cash in the form of deposits in their banks
(the banks use these deposits to advance loans to their clients) which increases the amount of
loanable funds in the loanable funds market and vice versa. The supply of loanable funds is thus
upward sloping.
Fig: Supply of loanable funds
Y
SLF
ii
i0
q0 q1 X
Y - Interest rates
X - Quantity of loanable funds

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Fig: The Interaction of supply and demand for loanable funds
Y
SLF
i0 e
DLF
q0 X
Y - Interest rates
X - Quantity of loanable funds
The interaction of demand and supply of loanable funds in the market lead to an equilibrium
point where the supply and demand of loanable funds is equal.
At point e supply of loanable funds = demand of loanable funds.
Government Budget Deficit
A government budget deficit refers to the case where the government expenditure
exceeds its income (Aiyagari, Christiano and Martin, 1990). This is as a result of the government
increasing its spending above the amount they collect from tax revenue. To finance the budget
deficit the government is forced to borrow from the private sector. This raises the interest rates as
the demand for loanable funds rises. Higher budget deficits may result to crowding out as less
funds are available to the private sector (Magill, 1997). A cut in government spending lowers the
budget deficit (with lower spending, the government can use its revenues (tax) to finance
operations and if they must borrow the borrowing is significantly lower). As a result, there will
be an increase in the amount of loanable funds available, as the government borrows less from
the people and businesses. This causes a shift in the supply of loanable funds curve to the right.
(From slf0 to slf1)

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This shifts creates a new equilibrium point ei at a lower interest rate li and a higher amount of
loanable funds qi. This leads to increased investments in the private sector (as the crowding out
is eliminated) and consequently greater growth.
Graph: Shift in the supply curve
Y
SLFo
SLF1
I0 E0
I1 E1
DLF
q0 q1 X
Y - Interest rates
X - Quantity of loanable funds
A cut in government spending will lower the budget deficit as a result lead to lower interest rates
(Kühn, Muysken and Veen, 2010).
Justification
The main tool used by the Federal Reserve to manipulate interest rate is through the
setting of the target federal funds rate. Banks are required to keep a certain amount of capital and
deposit with the Federal Reserve Bank known as federal funds. The federal funds vary
depending on the banks outstanding loans and deposit.it is acceptable for banks with excess
reserves to loan those that run short. The rate at which these loans are made out depends on the
current target federal funds rate. This funds rate forms the base upon which interest rates are
determined as it is passed through to businesses and consumer loans. (Americanexpress.com,
2018)

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Part B
A floating rate loan is also called a variable rate loan. For this type of loan, the interest
rate charged on the outstanding loan balance varies in line with the prevailing market interest
rates (Binder, 2017). This means that the interest payment will change depending on the
economic times (prevailing interest rates). Should the prevailing interest rates rise one is then
required to pay a higher interest than he/she did before. If at the time of repayment, the market
interest rate has fallen, one subsequently pays lower interest than before.
A fixed interest loan is one whose interest rate charged on the loan remains fixed for the
entire duration of the loan (The Guardian, 2018). The interest rate on the loan is pegged to the
prevailing interest rate at the time of entering into the loan contract. No matter the direction the
market interest rates take the loan interest rate remains unfazed. This is a two sided coin. On the
brighter side, the policy holder is protected from market fluctuations such that should the market
rates rise he/ she pays interest on the lower rate agreed upon. However, the policy holder ends up
paying a higher interest than he/she would have had they partaken in the flexible interest loan
should the market rates fall.
Recommendation and Justification
In the end there is no clear cut good option between these two; in the end it all depends
on the expected market interest rates trend. As illustrated in part (a) above, the United States
interest rates are projected to fall owing to the reduced government spending. In light of this I
would advise my company to consider taking the 8% floating rate loan in order to be able to take
advantage of the expected lower interest rates in this economic period if the loan is payable in
the short run. However, the 8% fixed interest rate loan is desirable for long term loans to
minimize variation risks.
Part C
Relationship between UK and US
The UK and the US are strong trade partners. This can be attributed to the fact that they
share common values as well as a common heritage (the US was once colonized by the Brits).
The UK is the United States’ fifth largest export market and the seventh largest source of imports
for the US. The US exports to the UK include machinery, vehicles, precious stones and metals,
electrical equipment, minerals, pharmaceuticals, agricultural, fish and forestry output, alcoholic

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beverages, branded snack foods, and grocery goods. The UK’s exports to US include cars,
packaged medications, nucleic acids and refined petroleum. The United States’ balance of trade
has ranged between a low of (-5380 in 2013) and a high of (4770.6) in 2011. The current sterling
pound to US dollar exchange rate is1.34072. Foreign direct investment between the two
countries is high. The US FDI in the UK concentrate on non-bank holding companies, finance
and insurance and the manufacturing sectors. On the other hand, the UK FDI in the US is mostly
in manufacturing, finance and insurance, banking, wholesale trade and the information.
A Raise in the Level of Interest Rates by the UK in UK
Higher interest rates are an incentive for consumers to save. This is because saving is
more profitable. Consumers consequently reduce their consumption now to increase their
savings. Businesses and companies now facing higher interest rates opt to hold on to their
resources rather than invest in the capital projects. This is due to the fact that in investing in
capital projects now only serves to lower their earnings on the projects as their net present value
is significantly lowered. There is therefore an increased supply of loanable funds in the loanable
funds market. This higher supply of loanable funds in the market shifts the loanable funds supply
curve to the right as illustrated in the figure above. The interaction of demand and supply of
loanable funds in the market results in a movement in the demand for loanable funds curve to a
higher quantity demand q1 and a lower interest rate i.e.
The higher interest rates also have an impact on the exchange of the sterling pound to the
other currencies. The higher interest rates increase the value of the UKs pound against the
currencies of other countries say US as in this case (Hnatkovska, Lahiri and Gramont, 2008).
This tends to make imports cheaper this is because for 1 GBP consumers can buy or pay for
more goods than before (you pay less than before with appreciation). Exports on the other hand
become more expensive than before in the sense that for every 1 GBP of goods and services
exported exporters get a lower return than before (Yung, 2014). This therefore increases the
quantity of imports vis-à-vis exports which translates into a trade deficit.
The higher interest rates also have an influence on foreign direct investment. FDI refers
to the investments made in a country not by its citizens by foreign nationals and companies.
Higher interest rates in the UK as compared to the US make investment in the UK more
attractive. As a result there will be increased investment in the UK by foreign companies and

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business resulting in what is commonly referred to as “hot money flows”. This is because
investors are always after highest yields with lowest risks possible. This is only too true
especially with UK’s established ease of doing business.
Effect of Higher Interest Rates in the UK on the US
The higher interest rates in the UK as compared to the US makes saving in the UK more
attractive to the American households than in the US (Carriero, 2006). This is due to the fact that
this will yield greater interest earnings on their savings. This is also true with businesses and
company’s .this greatly affects the money supply in the US economy resulting in lower supply of
funds in the loanable funds market in the US following the out flux. (The fact that the Federal
Reserve is not expected to affect the existing supply of loanable funds over the next year means
that any changes in the level of interest rates and loanable funds is left to the market mechanisms
of demand and supply to mitigate this problem).
Justification
With increased savings in the UK it means that consumption in the US is subsequently
lowered as households are keener on earning the higher interests. The subsequent lower money
supply means that there are fewer dollars chasing goods and services (the dollar now has a
stronger purchasing power). The lower demand forces suppliers of goods and services to lower
their prices in order to boost its demand. Following the law of demand where prices and demand
are inversely related then this would lead to increased demand for goods and services. To meet
this growing demand households will need more funds thus an increased demand for money in
the economy. This will shift the demand curve of loanable funds to the right from DLF0 to DLFi
shifting the equilibrium point from e0 to ei. This will cause a movement along the supply curve
SLF. At the original equilibrium point e0 the equilibrium interest rate and quantity of loanable
funds is i0 and q0 respectively. After the shift the new equilibrium point is ei with equilibrium
interest rate and quantity being ii and qi respectively.

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Fig: Shifting of the demand for loanable funds
Interest rate SLF
ii ei
i0 ei
DLFo
DLFo
q0 qi Quantity of loanable funds
The interest rate following the shift is higher and so is the quantity of loanable funds. Therefore,
an increase in the interest rate of the UK will lead to a rise in the interest rate of the US as well.

Interest Rates 12
Bibliography
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56(2), pp.875-894.
Carriero, A. (2006). Explaining US-UK Interest Rate Differentials: A Reassessment of the
Uncovered Interest Rate Parity in a Bayesian Framework*. Oxford Bulletin of Economics and
Statistics, 68, pp.879-899.
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Available at: https://www.reuters.com/article/us-usa-fed-inflation-analysis-idUSKBN19630N
[Accessed 20 May 2018].
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https://www.theguardian.com/business/interest-rates [Accessed 22 May 2018].
Yung, J. (2014). Can Interest Rate Factors Explain Exchange Rate Fluctuations? SSRN
Electronic Journal.