CH11 - 3 Factors affecting short-term interest rates

Question 1

1. Short-Term Interest Rates

Answer 1

• Controlled by the government through the central bank’s intervention in the money market.
• Benchmark Rate: Set by the central bank; influences all other short-term interest rates in the economy.
• The relationship between the government and the central bank varies:
  
  • Complete Independence: Central bank sets monetary policy independently.
  • Exclusive Government Control: Decisions made solely by the government.
  • Partial Independence: Central bank operates within constraints like inflation targets.

Question 2

2. Controlling Economic Growth

Answer 2

Low Real Interest Rates:
* Encourage investment spending by firms.
* Increase consumer spending by reducing borrowing costs.
* Result: Higher aggregate demand and short-term economic growth.

Example: Cutting interest rates to boost spending during a recession.

Question 3

3. Controlling Inflation

Answer 3

• Quantity Theory of Money:
  
  • Formula: 𝑀 × 𝑉 = 𝑃 × 𝑌 , where:
    
    • M: Money supply.
    • V: Velocity of circulation.
    • P: Price level.
    • Y: Real level of economic activity.
  • Assumptions: V and Y are constant in the short term.
  • Conclusion: Growth in money supply leads to inflation.
• Demand-Pull Inflation:
  * Caused by excess demand in the economy.
  * Firms raise prices due to increased demand.
  * Example: Higher spending during an economic boom.

Question 4

4. Controlling the Exchange Rate

Answer 4

• Low Interest Rates:
  * Decrease demand for domestic currency.
  * Result: Currency depreciation and lower exchange rates.
• High Interest Rates:
  * Attract foreign investors, supporting domestic currency value.
• Cost-Push Inflation: Caused by increased costs for firms, passed on as higher consumer prices.
• Sources:
  
  • Higher raw material prices.
  • Wage demands exceeding productivity.
  • Weakened domestic currency increasing import prices.

Question 5

5. Quantitative Easing (QE)

Answer 5

• Used when short-term interest rates are close to zero.
• How QE Works:
  
  • Central bank creates money electronically.
  • Buys assets (e.g., government bonds) to increase money supply.
  • Results:
    
    • Banks lend more.
    • Interest rates decrease further.
    • Asset prices (e.g., stocks, property) rise as investors seek higher yields.
    • Borrowing costs drop, encouraging business investment and consumer spending.
  • Boosts economic activity.

Example: Stock markets often rise when QE is announced.

Question 6

6. Negative Interest Rates

Answer 6

• Borrowers are credited with interest instead of paying it.
• When It Occurs:
  
  • Central bank lowers rates to zero or below to stimulate the economy (e.g., during a severe recession).
  • Example: Japan’s prolonged zero or negative interest rates.