Finance and Financial Markets

Third Edition

by Keith Pilbeam

Chapter 4 - Monetary Policy and Interest Rate Determination

Find an overview and useful learning resources below to accompany Finance and Financial Markets chapter four.

Chapter Introduction

The interest rate is the price that has to be paid by a borrower of money to a lender of money in return for the use of the funds. The rate of interest is a crucial economic variable which will affect the amount of consumption, saving and investment in an economy. It is a crucial part of the formula for pricing other financial assets such as forwards, futures, options and swaps, and for this reason a proper understanding of the factors that can cause interest rate changes is crucial to the study of financial markets.

Interest rates, whether short-term or long-term, are inextricably linked to the conduct of macroeconomic policy, especially monetary policy and future expectations about the conduct of economic policy. In this chapter we look at monetary policy and the fundamental forces that influence the general level of interest rates in an economy. We also make a crucial distinction between the nominal and real rates of interest. The chapter then examines the term structure of interest rates, or the yield curve, that is the plot of short-, medium- and long-term interest rates at any given point in time.

Learning Objectives

In this chapter you will learn about:

  • The differences between Treasury bills and Treasury bonds
  • Contractionary and expansionary open market operations
  • The commercial banking system and the narrow and broad monetary aggregates
  • The supply and demand for money
  • The impact of inflation expectations and inflation risk on long-term interest rates
  • The yield curve and what causes it to shift
  • The various theories of the yield curve such as the expectations theory, liquidity
  • Preference theory and expectations theory

Further Reading

Mishkin, F. (2009) Monetary Policy Strategy, MIT Press.

Walsh, C. (2003) Monetary Theory and Policy, 2nd edn, MIT Press.

Woodford, M. (2003) Interest and Prices: Foundations of a Theory of Monetary Policy, Princeton University Press.

Revision Questions

  1. ​Briefly explain with the aid of diagrams of the money market and Treasury bill market what happens when the central bank conducts a contractionary open market operation.
  2. Explain with the aid of an equation the three factors that determine long-term interest rates.
  3. Briefly explain what the yield curve is and draw a positively-sloped yield curve.
  4. Show the effect on the yield curve if the expected rate of inflation was to rise in both the short and the long term.
  5. The narrow money supply is ?100 million, the public’s desired cash to deposit ratio is 0.15 and the banking system’s reserve to deposit ratio is 0.1. What is the equilibrium value of the broad money supply?
  6. Briefly explain the liquidity preference theory and discuss its implication for the slope of the yield curve.

Multiple Choice Questions

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