Thursday, August 27, 2009

The functions of the rate of interest in the economy

The rate of interest performs several different and highly important roles in the economy:
-It helps guarantee that current savings will flow into investment to promote economic growth.
- the rate of interest rations the available supply of credit, generally providing loanable funds to those projects with the highest expected returns.
- it brings into balance the nation‘s supply of money with the demand for money.
- the rate of interest is also an important tool government policy through its influence upon the volume of saving and investment. If the economy is growing too slowly and unemployment is rising, the government can use its policy tools to lower interest rates in order to stimulate borrowing and investment. On the other hand, an overheated economy experiencing rapid inflation has traditionally called for a government policy of higher interest rates to slow both borrowing and spending.
in the pages of the financial press, the phrase "the interest rate" is frequently used, in truth, there is no such thing as "the interest rate" for there are thousands of different rates in the financial system. Even securities issued by the same borrower will often carry a variety of interest rates. In the next topic, the most important factors which cause rates to vary among different securities and over time are examined in detail. in this blog, our focus is upon those forces that influence the level of all interest rates.
To uncover these general and pervasive rate-determining forces, however, we must make a simplifying assumption. We will assume there is one fundamental interest rate in the economy known as the pure or risk-free rate of interest, which is a component of all rates. The closet approximation to this pure rate in the real world is the yield to maturity on long term U.S. Government bonds. it is a rate of return presenting no risk of financial loss to the investor and represents the true "opportunity cost" of holding idle money because the investor can always invest in risk-less securities and earn this minimum rate of return
Once the pure rate of interest is determined, all other interest rates may be determined from it by examining the special characteristics of the securities issued by individual borrowers. For example, only the government can borrow at the pure, risk-free interest rate; other borrowers pay higher rates than this due, in part, to the greater risk of loss attached to their securities. Difference in liquidity, marketability, and maturity are other important factors causing various interest rates to differ from the pure, risk-free rate. First, however, we must examine the forces which determine the risk-free rate itself.

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