Expectations and Interest Rate Changes in Economics

Neutral Rate of Interest

• The neutral rate is the rate of interest that neither stimulates nor slows down the underlying economy.
• It is the average policy rate over a business cycle.
• The neutral policy rate consists of the real trend rate of growth of the underlying economy and long-run expected inflation.
• Example: Neutral policy rate = trend growth + inflation target = 3% + 2% = 5%.
• If policy rate is above 5%, monetary policy is contractionary; if below 5%, it is expansionary.

Official Interest Rate

• The official interest rate is set by the central bank to influence short- and long-term interest rates and real economic activity.
• It is the rate at which the central bank is willing to lend money to commercial banks.
• The policy rate can be achieved by using short-term collateralized lending rates called repo rates.

Money Neutrality Concept

• States that the real rate of interest in an economy is stable over time, so changes in nominal interest rate result from changes in expected inflation.

Expectations and Interest Rate

• Economic agents view an increase in interest rate as a slowdown in economic activity and growth, reducing profits and borrowing.
• Expectations influence investment and purchasing decisions of companies and individuals.
• An increase in the official policy rate can lead to a reduction in domestic demand and net external demand, putting downward pressure on the rate of domestic inflation.

Central Bank Funds Rate

• Commercial banks are required to deposit a certain percentage of their checkable account deposits as a reserve.
• Excess reserves are lent to other banks that temporarily need them to meet their reserve requirements.
• The interest rate of reserves held by the central bank is less than the interest rate earned from overnight loans to other banks.
• An equilibrium interest rate, Central Bank Funds rate, arises in the market for bank reserves.

Targeting Central Bank Funds Rate

• The central bank targets the CB funds by manipulating the supply of reserves in the CB funds market.
• Buying and selling government bonds decrease or increase the reserves in the banking system, affecting the excess reserve available for supply to the CB funds market.

Monetary Policy Tools

• Three tools of the Central Bank to alter the reserves of commercial banks:
  • Open-market operations
  • The reserve ratio
  • The discount rates

Open-Market Operations

• Buying or selling government bonds from/to commercial banks and the public.
• Buying securities from commercial banks:
  • Creates a shortage of money, forcing banks to sell bonds to the central bank with a pre-agreed repurchase price.
  • Increases the reserves of commercial banks, increasing lending ability and money supply in the form of checkable deposits.
• Selling securities to commercial banks:
  • Increases the reserves of commercial banks, increasing lending ability and money supply.
  • Increases the lending ability of the commercial banking system, increasing money supply in the form of checkable deposits.