Controlling Interest Rates

Essentially, the term “interest rates” stands for a monetary compensation, usually expressed in a percentage per annum. The lender of the fiscal amount is compensated for the loss that he or she suffers – the owner of the money may invest them and thus generate income instead of lending funds to the borrower.

One of the ways a central bank (or a reserve bank or other monetary authority) may control interest rates is by open market operations. A central bank may indirectly intervene in the economy of its country or union of states by buying government securities. By purchases, the bank raises the price of the securities on the open market, thus lowering their rates and the interest rates in general.

The interest rates may be modified directly by the respective monetary institution, as well. After all, interest rates are just tools of monetary policy and may be used to curb variables like investment and inflation. Historically speaking, interest rates have been governed by national governments or central banks. The Fed’s federal funds rate in the US has fluctuated from 0.25% to 19% for the period between 1954 and 2008. Variations in the base rate of the Bank of England from 1989 to 2009 measured from lowest 0.5% to a high of 15%. But for the layman’s mind, it is noteworthy to point out that the generally referred to (in media) as interest rate is the annualized rate offered by a respective central bank on overnight deposits.

As a matter of fact, there are some authors such as Daniel L. Thornton, from Federal Reserve Bank of St. Louis, who argue that “it is money that matters and interest rates does not”, due to the perceived virtuality of the interbank interest rates. Further Thornton points out that monetary policy is at present conducted by targeting short-term interest rates. The banking authorities undertake to manage the price level by manipulating aggregate demand while fixing their targeted interest rate. So, the aforementioned author claims that money’s role is at best tertiary. Even more, the author points out that according to some other renowned economists, money is probably irrelevant in the determination of the price level. But the author of the working paper argues against these macroeconomists, claiming that the most prominent feature of money is its ability to warrant “final payment”. He also suggests that the central banks’ ability to control interest rates may be overtly exaggerated.

The author reports that according to Friedman (1999) “a widely shared opinion today is that central banks need not actually do anything. With a clear enough statement of intentions, ‘the markets will do all of the work for them’ as far as controlling the funds rates in view of the target for the funds rate is concerned (funds rate = the interest rate at which a depository institution lends available funds straightforward to another depository for the overnight). The author further clarifies the EH (expectations hypothesis), stating that “a longer-term rate is equal to the average of the current and expected future short-term rate”. Then, he concludes that this hypothesis would mean, if true, that all rates would be linked with the overnight rate; but the aforementioned hypothesis has been proven wrong numerous times by authors such as Campbell and Shiller, Cochrane and Piazzesi, and Thornton himself. The apparent erroneousness of the EH proposition gives ground to deeply doubt FED's means of controlling the interest rates by applying the apparatus of the expectations hypothesis.

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