Have you ever wondered what the people on the news are talking about when they say something like, “The Dow Jones Industrial Average closed up 30 points today on heavy trading. The S&P 500 also edged higher. The NASDAQ was mixed. Foreign markets opened lower on news that the Fed will maintain near-zero interest rates for the foreseeable future. Corporate bond prices sank as many issues were downgraded while the yield on the ten-year treasury ended lower”?
If you subscribe to the Wall Street Journal or Financial Times, or regularly watch CNBC, Bloomberg, or the Fox Business channel, you probably understand the lingo. But if you’re like many Americans, the financial markets are a complete mystery. Even though they appear complicated, financial markets serve a very basic purpose: to connect the people who have money with the people who want money.
Economists offer a simple model for understanding financial markets and how the real interest rate is determined. (Remember that the real interest rate is the amount of nominal interest left standing after the rate of inflation is accounted for/subtracted.) Like many bright ideas economists come up with, this model is purely imaginary but it helps to explain what happens in financial markets. The hypothetical market they’ve identified is referred to as the loanable funds market. It exists to bring together “savers” and “borrowers.” Savers supply and borrowers demand. The real interest rate occurs at the point where the amount saved equals the amount borrowed.
According to the law of supply, producers are only willing to offer more if they can collect a higher price because they face ever-increasing costs. In the loanable funds market, the price is the real interest rate. Savers, the producers of loanable funds, respond to the price by offering more funds as the rate increases and less as the rate decreases. Borrowers act as consumers of loanable funds—their behavior is explained by the law of demand. When the interest rate is high, they are less willing and able to borrow, and when interest rates are low, they are more willing and able to borrow.
Newcomers to economics are often confused by the use of the term investment. In economics, investment means borrowing in order to purchase physical capital. If the topic is stocks and bonds, then investment is understood to mean pretty much the same thing as saving. Savers engage in financial investment, which provides the funds for borrowers to engage in capital investment.
According to the expanded view of the loanable funds theory, savers are represented by households, businesses, governments, and the foreign sector. Borrowers also are represented by these same sectors. Changes in the saving and borrowing behavior of the various sectors of the economy result in change in the real interest rate and change in the quantity of loanable funds exchanged. For example, a decision by foreign savers to save more in the United States results in a lower real interest rate and a greater quantity of loanable funds exchanged for the country. A decision by the U.S. government to borrow money and engage in deficit spending would increase the demand for loanable funds, and result in a higher real interest rate and a greater quantity of loanable funds exchanged. The loanable funds theory of interest rate determination is useful for understanding changes in long-term interest rates.
John Maynard Keynes’s liquidity preference theory explains short-term nominal interest rates. Instead of looking at saving and borrowing behavior as the determinant of interest rates, Keynes taught that short-term interest rates are a function of consumers’ liquidity preference or inclination for holding cash. In Keynes’s theory, the money market, as opposed to the loanable funds market, was central to explaining interest rates.
The money market is where the central bank supplies money, and households, businesses, and government demand money at various nominal interest rates. Central banks like America’s Federal Reserve act as regulated monopolies and issue money independent of the interest rate. Liquidity preference is the demand for money. At high nominal interest rates, people would rather hold interest-bearing non-cash assets like bonds, but as interest rates fall, people are more willing to hold cash as an asset because they are not sacrificing much interest to do so.
Why are there two theories of interest rate determination? Economists have competing theories for many economic phenomena. Interest rates are just one of many concepts on which economists have differing points of view. The loanable funds theory is associated with classical economics, whereas the money market theory is associated with Keynesian economics.
If the Fed wants to lower the nominal interest rate to encourage investment and consumption, they increase the money supply, and if they wish to raise nominal interest rates in order to curtail investment and consumption, they decrease the available supply of money. Increases or decreases in the nominal gross domestic product cause the demand for money to either increase or decrease.
Assuming that the Fed holds the supply of money constant, increases in money demand result in a higher nominal interest rate, whereas decreases in money demand reduce the nominal interest rate.