monetary policy and interest rate

8/9/2019 Monetary Policy and Interest Rate

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3 &ypes

o 3.1 (nflation targeting

o 3.2 +rice leel targeting

o 3.3 Monetary aggregates

o 3.$ Fixed exchange rate

o 3. 'old standard

$ +olicy tools

o $.1 Monetary base

o $.2 -esere reuirements

o $.3 *iscount window lending

o $.$ (nterest rates

o $. #urrency board

o $./ 0nconentional monetary policy at the ero bound

ee also

/ otes and references

4 "xternal lin!s

Overview[edit]
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(nflation and the growth rate of money supply 5M26 in the 0nited tates, 174 to 2811.

Monetary policy, to a great extent, is the management of expectations. []Monetary policy rests on the

relationship between the rates of interest in an economy, that is, the price at which money can be

borrowed, and the total supply of money. Monetary policy uses a ariety of tools to control one orboth of these, to influence outcomes li!e economic growth,inflation,"9#):'" -:&" with

other currencies andunemployment. ;here currency is under a monopoly of issuance, or where

there is a regulated system of issuing currency through ban!s which are tied to a central ban!, the

monetary authority has the ability to alter the money supply and thus influence the interest rate 5to

achiee policy goals6. &he beginning of monetary policy as such comes from the late 1 neutral, if it is intended neither to create growth nor combat inflation> or

tight if intended to reduce inflation.

&here are seeral monetary policy tools aailable to achiee these ends= increasing interest rates by

fiat> reducing themonetary base> and increasing resere reuirements.:ll hae the effect of

contracting the money supply> and, if reersed, expand the money supply. ince the 1


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specific "9#):'" -:&" relatie to some foreign currency or else relatie to gold. For example,

in the case of the 0: the Federal -esere targets thefederal funds rate,the rate at which member

ban!s lend to one another oernight> howeer, the monetary policy of #hinais to target theexchange

ratebetween the #hineserenminbiand a bas!et of foreign currencies.

&he other primary means of conducting monetary policy include= 5i6*iscount windowlending 5lender

of last resort6> 5ii6 Fractional deposit lending 5changes in the resere reuirement6> 5iii6 Moral

suasion5Eobbying certain mar!et players to achiee specified outcomes6> 5i6 %pen Mouth

%perations 5tal!ing monetary policy with the mar!et6.

&heory[edit]

General[edit]

&his article reads like an editorial or opinion piece. +leasehelp improe this ar

rewriting it in anencyclopedic styleto ma!e itneutralin tone. ee;+=o original

researchand;+=%&%+((%for further details.(December 2014)

Monetary policy is the process by which the goernment, central ban!, or monetary authority of a

country controls 5i6 the supply of money, 5ii6 aailability of money, and 5iii6 cost of money or rate of

interest to attain a set of ob@ecties oriented towards the growth and stability of the economy.[1]

Monetary theory proides insight into how to craft optimal monetary policy.

Monetary policy rests on the relationship between the rates of interest in an economy, that is theprice at which money can be borrowed, and the total supply of money. Monetary policy uses a

ariety of tools to control one or both of these, to influence outcomes li!e economic growth,

inflation, "9#):'" -:&" with other currencies and unemployment. ;here currency is under a

monopoly of issuance, or where there is a regulated system of issuing currency through ban!s which

are tied to a central ban!, the monetary authority has the ability to alter the money supply and thus

influence the interest rate 5to achiee policy goals6.

(t is important for policyma!ers to ma!e credible announcements. (f priate agents

5consumersand firms6 beliee that policyma!ers are committed to loweringinflation, they will

anticipate future prices to be lower than otherwise 5how those expectations are formed is an entirely

different matter> compare for instancerational expectationswith adaptie expectations6. (f an

employee expects prices to be high in the future, he or she will draw up a wage contract with a high

wage to match these prices. [citation needed])ence, the expectation of lower wages is reflected in wageD

setting behaior between employees and employers 5lower wages since prices are expected to be

lower6 and since wages are in fact lower there is no demand pull inflationbecause employees are
http://en.wikipedia.org/wiki/Monetary_policyhttp://en.wikipedia.org/wiki/Federal_funds_ratehttp://en.wikipedia.org/wiki/Federal_funds_ratehttp://en.wikipedia.org/wiki/Federal_funds_ratehttp://en.wikipedia.org/wiki/Monetary_policy_of_Chinahttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Renminbihttp://en.wikipedia.org/wiki/Renminbihttp://en.wikipedia.org/wiki/Discount_windowhttp://en.wikipedia.org/wiki/Discount_windowhttp://en.wikipedia.org/wiki/Discount_windowhttp://en.wikipedia.org/wiki/Lender_of_last_resorthttp://en.wikipedia.org/wiki/Lender_of_last_resorthttp://en.wikipedia.org/wiki/Moral_suasionhttp://en.wikipedia.org/wiki/Moral_suasionhttp://en.wikipedia.org/wiki/Moral_suasionhttp://en.wikipedia.org/w/index.php?title=Monetary_policy&action=edit&section=2http://en.wikipedia.org/w/index.php?title=Monetary_policy&action=edit&section=3http://en.wikipedia.org/wiki/Wikipedia:EDITORIALhttp://en.wikipedia.org/w/index.php?title=Monetary_policy&action=edithttp://en.wikipedia.org/w/index.php?title=Monetary_policy&action=edithttp://en.wikipedia.org/wiki/Wikipedia:TONEhttp://en.wikipedia.org/wiki/Wikipedia:TONEhttp://en.wikipedia.org/wiki/Wikipedia:NPOVhttp://en.wikipedia.org/wiki/Wikipedia:NPOVhttp://en.wikipedia.org/wiki/Wikipedia:No_original_researchhttp://en.wikipedia.org/wiki/Wikipedia:No_original_researchhttp://en.wikipedia.org/wiki/Wikipedia:No_original_researchhttp://en.wikipedia.org/wiki/Wikipedia:No_original_researchhttp://en.wikipedia.org/wiki/Wikipedia:NOTOPINIONhttp://en.wikipedia.org/wiki/Wikipedia:NOTOPINIONhttp://en.wikipedia.org/wiki/Monetary_policyhttp://en.wikipedia.org/wiki/Signalling_(economics)http://en.wikipedia.org/wiki/Consumerhttp://en.wikipedia.org/wiki/Corporationhttp://en.wikipedia.org/wiki/Inflationhttp://en.wikipedia.org/wiki/Rational_expectationshttp://en.wikipedia.org/wiki/Adaptive_expectationshttp://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Demand_pull_inflationhttp://en.wikipedia.org/wiki/Monetary_policyhttp://en.wikipedia.org/wiki/Federal_funds_ratehttp://en.wikipedia.org/wiki/Monetary_policy_of_Chinahttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Exchange_ratehttp://en.wikipedia.org/wiki/Renminbihttp://en.wikipedia.org/wiki/Discount_windowhttp://en.wikipedia.org/wiki/Lender_of_last_resorthttp://en.wikipedia.org/wiki/Lender_of_last_resorthttp://en.wikipedia.org/wiki/Moral_suasionhttp://en.wikipedia.org/wiki/Moral_suasionhttp://en.wikipedia.org/w/index.php?title=Monetary_policy&action=edit&section=2http://en.wikipedia.org/w/index.php?title=Monetary_policy&action=edit&section=3http://en.wikipedia.org/wiki/Wikipedia:EDITORIALhttp://en.wikipedia.org/w/index.php?title=Monetary_policy&action=edithttp://en.wikipedia.org/wiki/Wikipedia:TONEhttp://en.wikipedia.org/wiki/Wikipedia:NPOVhttp://en.wikipedia.org/wiki/Wikipedia:No_original_researchhttp://en.wikipedia.org/wiki/Wikipedia:No_original_researchhttp://en.wikipedia.org/wiki/Wikipedia:NOTOPINIONhttp://en.wikipedia.org/wiki/Monetary_policyhttp://en.wikipedia.org/wiki/Signalling_(economics)http://en.wikipedia.org/wiki/Consumerhttp://en.wikipedia.org/wiki/Corporationhttp://en.wikipedia.org/wiki/Inflationhttp://en.wikipedia.org/wiki/Rational_expectationshttp://en.wikipedia.org/wiki/Adaptive_expectationshttp://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Demand_pull_inflation


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receiing a smaller wage and there is no cost push inflationbecause employers are paying out less

in wages.

&o achiee this low leel of inflation, policyma!ers must hae credibleannouncements> that is,

priate agents must beliee that these announcements will reflect actual future policy. (f anannouncement about lowDleel inflation targets is made but not belieed by priate agents, wageD

setting will anticipate highDleel inflation and so wages will be higher and inflation will rise. : high

wage will increase a consumerAs demand 5demand pull inflation6 and a firmAs costs 5cost push

inflation6, so inflation rises. )ence, if a policyma!erAs announcements regarding monetary policy are

not credible, policy will not hae the desired effect.

(f policyma!ers beliee that priate agents anticipate low inflation, they hae an incentie to adopt an

expansionist monetary policy 5where the marginal benefitof increasing economic output outweighs

themarginal costof inflation6> howeer, assuming priate agents haerational expectations, they

!now that policyma!ers hae this incentie. )ence, priate agents !now that if they anticipate low

inflation, an expansionist policy will be adopted that causes a rise in inflation. #onseuently, 5unless

policyma!ers can ma!e their announcement of low inflation credible6, priate agents expect high

inflation. &his anticipation is fulfilled through adaptie expectation 5wageDsetting behaior6>so, there

is higher inflation 5without the benefit of increased output6. )ence, unless credible announcements

can be made, expansionary monetary policy will fail.

:nnouncements can be made credible in arious ways. %ne is to establish an independent central

ban! with low inflation targets 5but no output targets6. )ence, priate agents !now that inflation will

be low because it is set by an independent body. #entral ban!s can be gien incenties to meet

targets 5for example, larger budgets, a wage bonus for the head of the ban!6 to increase their

reputation and signal a strong commitment to a policy goal. -eputation is an important element in

monetary policy implementation. ?ut the idea of reputation should not be confused with commitment.

: central ban! might hae a faorable reputation due to good performance in conducting monetary

policy, the same central ban! might not hae chosen any particular form of commitment 5such as

targeting a certain range for inflation6. -eputation plays a crucial role in determining how much

mar!ets would beliee the announcement of a particular commitment to a policy goal but both

concepts should not be assimilated. :lso, note that under rational expectations, it is not necessaryfor the policyma!er to hae established its reputation through past policy actions> as an example, the

reputation of the head of the central ban! might be deried entirely from his or her ideology,

professional bac!ground, public statements, etc.

(t has been argued[/]that to preent some pathologies related to thetime inconsistencyof monetary

policy implementation 5in particular excessie inflation6, the head of a central ban! should hae a
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larger distaste for inflation than the rest of the economy on aerage. )ence the reputation of a

particular central ban! is not necessarily tied to past performance, but rather to particular institutional

arrangements that the mar!ets can use to form inflation expectations.

*espite the freuent discussion of credibility as it relates to monetary policy, the exact meaning ofcredibility is rarely defined. uch lac! of clarity can sere to lead policy away from what is belieed to

be the most beneficial. For example, capability to sere the public interest is one definition of

credibility often associated with central ban!s. &he reliability with which a central ban! !eeps its

promises is also a common definition. ;hile eeryone most li!ely agrees a central ban! should not

lie to the public, wide disagreement exists on how a central ban! can best sere the public interest.

&herefore, lac! of definition can lead people to beliee they are supporting one particular policy of

credibility when they are really supporting another.[4]

International economics[edit]

%ptimal monetary policy in international economics is concerned with the uestion of how monetary

policy should be conducted in interdependentopen economies. &heclassical iewholds that

international macroeconomic interdependence is only releant if it affects domestic output gaps and

inflation, and monetary policy prescriptions can abstract from openness without harm. [7]:s stressed

by #orsetti and +esenti 52886 [


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central ban!s by industrialiing nations was associated then with the desire to maintain the nationAs

peg to thegold standard,and to trade in a narrow bandwith other'%E* Dbac!ed currencies. &o

accomplish this end, central ban!s as part of the gold standard began setting the interest rates that

they charged, both their own borrowers, and other ban!s who reuired liuidity. &he maintenance of

a gold standard reuired almost monthly ad@ustments of interest rates.

*uring the 1748J1


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financialderiatiessuch as options, swaps, futures contracts, etc.

&rends in central ban!ing[edit]

&he central ban! influences interest rates by expanding or contracting the monetary base, which

consists ofcurrencyin circulation and ban!sA reseres on deposit at the central ban!. &he primary

way that the central ban! can affect the monetary base is byopen mar!et operationsor sales and

purchases of second hand goernment debt, or by changing the resere reuirements.(f the central

ban! wishes to lower interest rates, it purchases goernment debt, thereby increasing the amount of

cash in circulation or crediting ban!sA resere accounts.:lternatiely, it can lower the interest rate on

discounts or oerdrafts 5loans to ban!s secured by suitable collateral, specified by the central ban!6.

(f the interest rate on such transactions is sufficiently low, commercial ban!s can borrow from the

central ban! to meet resere reuirements and use the additional liuidity to expand their balance

sheets, increasing the credit aailable to the economy. Eowering resere reuirements has a similar

effect, freeing up funds for ban!s to increase loans or buy other profitable assets.

: central ban! can only operate a truly independent monetary policy when theexchange rateis

floating.[2](f the exchange rate is pegged or managed in any way, the central ban! will hae to

purchase or sell foreign exchange. &hese transactions in foreign exchange will hae an effect on the

monetary base analogous to open mar!et purchases and sales of goernment debt> if the central

ban! buys foreign exchange, the monetary base expands, and ice ersa. ?ut een in the case of a

pure floating exchange rate,central ban!s and monetary authorities can at best lean against the

wind in a world where capital is mobile.

:ccordingly, the management of the exchange rate will influence domestic monetary conditions. &o

maintain its monetary policy target, the central ban! will hae to sterilie or offset its foreign

exchange operations. For example, if a central ban! buys foreign exchange 5to counteract

appreciation of the exchange rate6, base money will increase. &herefore, to sterilie that increase,

the central ban! must also sell goernment debt to contract the monetary base by an eual amount.

(t follows that turbulent actiity in foreign exchange mar!etscan cause a central ban! to lose control

of domestic monetary policy when it is also managing the exchange rate.

(n the 1


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(n the 1


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5usually goernment obligations6. &hese open mar!et operationschange either the amount of money

or its liuidity 5if less liuid forms of money are bought or sold6. &hemultiplier effectoffractional

resere ban!ingamplifies the effects of these actions.

#onstant mar!et transactions by the monetary authority modify the supply of currency and thisimpacts other mar!et ariables such as shortDterm interest ratesand the"9#):'" -:&" .

&he distinction between the arious types of monetary policy lies primarily with the set of instruments

and target ariables that are used by the monetary authority to achiee their goals.

Monetary Policy: Target Market Variable: Long Term Objective:

(nflation &argeting(nterest rate on oernight

debt: gien rate of change in the #+(

+rice Eeel &argeting(nterest rate on oernight

debt: specific #+( number

Monetary :ggregates&he growth in money

supply: gien rate of change in the #+(

Fixed"9#):'" -:&" &he spot price of the

currency&he spot price of the currency

'%E* tandard &he spot price of '%E*Eow inflation as measured by the'%E*

+-(#"

Mixed +olicy 0sually interest rates 0sually unemployment N #+( change

&he different types of policy are also called monetary regimes, in parallel toexchangeDrate regimes.

: fixed"9#):'" -:&" is also an exchangeDrate regime> &he 'old standard results in a

relatiely fixed regime towards the currency of other countries on the gold standard and a floating

regime towards those that are not. &argeting inflation, the price leel or other monetary aggregates

implies floating exchange rate unless the management of the releant foreign currencies is trac!ing

exactly the same ariables 5such as a harmonied consumer price index6.

(n economics, an expansionary fiscal policy includes higher spending and tax cuts, that encourage

economic growth.[24](n turn, an expansionary monetary policy is one that see!s to increase the sie

of the money supply. :s usual, inciting of money supply is aimed at lowering the interest rates on

purpose to achiee economic growth by increase of economic actiity.[27]#onersely, contractionary
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monetary policy see!s to reduce the sie of the money supply. (n most nations, monetary policy is

controlled by either acentral ban!or afinance ministry. eoclassicalandeynesian

economicssignificantly differ on the effects and effectieness of monetary policy on influencing

the realeconomy> there is no clear consensus on how monetary policy affects real economic

ariables 5aggregate output or income, employment6. ?oth economic schools accept that monetarypolicy affects monetary ariables 5price leels, interest rates6.

(nflation targeting[edit]

Main article:Inflation targeting

0nder this policy approach the target is to !eepinflation, under a particular definition such

as #onsumer +rice (ndex, within a desired range.

&he inflation target is achieed through periodic ad@ustments to the #entral ?an! interest ratetarget.

&he interest rate used is generally the oernight rateat which ban!s lend to each other oernight for

cash flow purposes. *epending on the country this particular interest rate might be called the cash

rate or something similar.

&he interest rate target is maintained for a specific duration using open mar!et operations. &ypically

the duration that the interest rate target is !ept constant will ary between months and years. &his

interest rate target is usually reiewed on a monthly or uarterly basis by a policy committee.

#hanges to the interest rate target are made in response to arious mar!et indicators in an attemptto forecast economic trends and in so doing !eep the mar!et on trac! towards achieing the defined

inflation target. For example, one simple method of inflation targeting called the &aylor rulead@usts

the interest rate in response to changes in the inflation rate and the output gap. &he rule was

proposed by Cohn ?. &ayloroftanford 0niersity.[2


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increases to consumers. 0nder inflation targeting what happened in the immediate past years is not

ta!en into account or ad@usted for in the current and future years.

0ncertainty in price leels can create uncertainty aroundpriceandwagesetting actiity for firms and

wor!ers, and undermines any informationthat can be gained from relatie prices, as it is moredifficult for firms to determine if a change in thepriceof agoodor sericeis because of inflationor

other factors, such as an increase in the efficiencyof factors of production, ifinflationis high

andolatile.:n increase in inflationalso leads to a decrease in the demand for money, as it reduces

theincentieto hold money and increases transaction costsand shoe leather costs.

Monetary aggregates[edit]

(n the 1


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cost of each transaction, which means that prices of goods and serices fall, and each unit of money

increases in alue. :bsent precautionary measures, deflation would tend to increase the ratio of the

real alue of nominal debts to physical assets oer time. For example, during deflation, nominal debt

and the monthly nominal cost of a fixedDrate home mortgage stays the same, een while the dollar

alue of the house falls, and the alue of the dollars reuired to pay the mortgage goesup."conomistsgenerally consider such deflation to be a ma@or disadantage of the gold standard.

0nsustainable 5i.e. excessie6 deflation can cause problems during recessionsand financial

crisislengthening the amount of time an economy spends in recession. ;illiam Cennings ?ryanrose

to national prominence when he built his historic 5though unsuccessful6 17


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expanding economic actiity. ?an!s must !eep ban!ing reseres [$1][$2]on hand to handle actual

cash needs, but they can lend an amount eual to seeral times their actual reseres. &he

money lent out by ban!s increases the money supply, and too much money 5whether lent or

printed6 will lead to inflation. #entral ban!s manage systemic ris!s by maintaining a balance

between expansionary economic actiity through ban! lending and control of inflation throughresere reuirements.[$3]

&hese three approaches DD openDmar!et actiities, setting ban!ingDsystem lending or interest rates,

and setting ban!ingDsystem resere reuirements to manage systemic ris! DD are the normal

methods used by central ban!s to ensure an adeuate money supply to sustain and expand an

economy and to manage or limit the effects of recessions and inflation. &hese standard supply,

demand, and ris! management tools !eep mar!et interest rates and inflation at specified target

alues by balancing the ban!ing systemAs supply of money against the demands of the aggregate

mar!et.

Monetary base[edit]

Monetary policy can be implemented by changing the sie of the monetary base.#entral ban!s

use open mar!et operationsto change the monetary base. &he central ban! buys or sells resere

assets 5usually financial instruments such as bonds6 in exchange for money on deposit at the central

ban!. &hose deposits are conertible to currency. &ogether such currency and deposits constitute

the monetary base which is the general liabilities of the central ban! in its own monetary unit.

0sually other ban!s can use base money as a fractional resereand expand the circulating money

supply by a larger amount.

-esere reuirements[edit]

&he monetary authority exerts regulatory control oer ban!s. Monetary policy can be implemented

by changing the proportion of total assets that ban!s must hold in resere with the central ban!.

?an!s only maintain a small portion of their assets as cash aailable for immediate withdrawal> the

rest is inested in illiuid assets li!e mortgages and loans. ?y changing the proportion of total assets

to be held as liuid cash, the Federal -esere changes the aailability of loanable funds. &his acts

as a change in the money supply. #entral ban!s typically do not change the resere reuirementsoften as it can create olatile changes in the money supply and may disrupt the ban!ing system.

*iscount window lending[edit]

Main article:Discount indo
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#entral ban!s normally offer a discount window, where commercial ban!s and other depository

institutions are able to borrow reseres from the #entral ?an! to meet temporary shortages of

liuidity caused by internal or external disruptions. &his creates a stable financial enironment where

saings and inestment can occur, allowing for the growth of the economy as a whole.

&he interest rate charged 5called the Adiscount rateA6 is usually set below short term interban! mar!et

rates. :ccessing the discount window allows institutions to ary credit conditions 5i.e., the amount of

money they hae to loan out6, thereby affecting the money supply. &hrough the discount window, the

central ban! can affect the economic enironment, and thus unemployment and economic growth.

(nterest rates[edit]

Main article:Interest rate

&he contraction of the monetary supply can be achieed indirectl!by increasing thenominal interest

rates.Monetary authorities in different nations hae differing leels of control of economyDwide

interest rates. (n the 0nited tates, the Federal -eserecan set the discount rate, as well as

achiee the desired Federal funds rateby open mar!et operations. &his rate has significant effect on

other mar!et interest rates, but there is no perfect relationship. (n the 0nited tates open mar!et

operations are a relatiely small part of the total olume in the bond mar!et. %ne cannot set

independent targets for both the monetary base and the interest rate because they are both modified

by a single tool O open mar!et operations> one must choose which one to control. : metaDanalysis

of 48 empirical studies on monetary transmission finds that a oneDpercentageDpoint increase in the

interest rate typically leads to a 8.3L decrease in prices with the maximum effect occurring between/ and 12 months.[$$]

(n other nations, the monetary authority may be able to mandate specific interest rates on loans,

saings accounts or other financial assets. ?y raising the interest rate5s6 under its control, a

monetary authority can contract themoney supply,because higher interest rates encourage saings

and discourage borrowing. ?oth of these effects reduce the sie of the money supply.

#urrency board[edit]

Main article:"urrenc! board

: currency board is a monetary arrangement that pegs the monetary base of one country to another,

the anchor nation. :s such, it essentially operates as a hard fixed "9#):'" -:&" , whereby

local currency in circulation is bac!ed by foreign currency from the anchor nation at a fixed rate.

&hus, to grow the local monetary base an euialent amount of foreign currency must be held in
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reseres with the currency board. &his limits the possibility for the local monetary authority to inflate

or pursue other ob@ecties. &he principal rationales behind a currency board are threefold=

1. &o import monetary credibility of the anchor nation>

2. &o maintain a fixed"9#):'" -:&" with the anchor nation>

3. &o establish credibility with the "9#):'" -:&" 5the currency board arrangement is the

hardest form of fixed "9#):'" -:&" outside of dollariation6.

(n theory, it is possible that a country may peg the local currency to more than one foreign currency>

although, in practice this has neer happened 5and it would be a more complicated to run than a

simple singleDcurrency currency board6. : gold standardis a special case of a currency board where

the alue of the national currency is lin!ed to the alue of'%E* instead of a foreign currency.

&he currency board in uestion will no longer issuefiat moneybut instead will only issue a set

number of units of local currency for each unit of foreign currency it has in its ault. &he surplus on

thebalance of paymentsof that country is reflected by higher depositslocal ban!s hold at the central

ban! as well as 5initially6 higher deposits of the 5net6 exporting firms at their local ban!s. &he growth

of the domestic money supplycan now be coupled to the additional deposits of the ban!s at the

central ban! that euals additional hard foreign exchange reseresin the hands of the central ban!.

&he irtue of this system is that uestions of currency stability no longer apply. &he drawbac!s are

that the country no longer has the ability to set monetary policy according to other domestic

considerations, and that the fixed exchange rate will, to a large extent, also fix a countryAs terms oftrade, irrespectie of economic differences between it and its trading partners.

)ong ongoperates a currency board, as does?ulgaria. "stoniaestablished a currency board

pegged to the *eutschmar! in 1


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%ther forms of monetary policy, particularly used when interest rates are at or near 8L and there are

concerns about deflation or deflation is occurring, are referred to as unconventional monetary

policy. &hese include credit easing, uantitatie easing,andsignaling. (n credit easing, a central

ban! purchases priate sector assets to improe liuidity and improe access to credit. ignaling

can be used to lower mar!et expectations for lower interest rates in the future. For example, duringthe credit crisis of 2887, the 0 Federal -esere indicated rates would be low for an Pextended

periodQ, and the?an! of #anadamade a Pconditional commitmentQ to !eep rates at the lower bound

of 2 basis points 58.2L6 until the end of the second uarter of 2818.

See also[edit]

(nteraction between monetary and fiscal policies

(nterest on excess reseres

Macroeconomic model

Monetary conditions index

Monetary reform

egatie interest on excess reseres

U speci!ic:

'reenspan put

Notes and references[edit]

1. "ump up #

:n interest rateis the rate at which interestis paid by borrowers 5debtors6 for the use of money that

they borrow fromlenders5creditors6. pecifically, the interest rate is a percentageof principalpaid a

certain number of times per period for all periods during the total term of the loan or credit. (nterest

rates are normally expressed as a percentage of the principal for a period of one year, sometimes

they are expressed for different periods li!e for a month or a day. *ifferent interest rates exist

parallely for the same or comparable time periods, depending on the default probability of the
http://en.wikipedia.org/wiki/Quantitative_easing#Credit_easinghttp://en.wikipedia.org/wiki/Quantitative_easinghttp://en.wikipedia.org/wiki/Quantitative_easinghttp://en.wikipedia.org/wiki/Signalling_(economics)http://en.wikipedia.org/wiki/Signalling_(economics)http://en.wikipedia.org/wiki/Bank_of_Canadahttp://en.wikipedia.org/wiki/Bank_of_Canadahttp://en.wikipedia.org/w/index.php?title=Monetary_policy&action=edit&section=21http://en.wikipedia.org/wiki/Interaction_between_monetary_and_fiscal_policieshttp://en.wikipedia.org/wiki/Interest_on_excess_reserveshttp://en.wikipedia.org/wiki/Macroeconomic_modelhttp://en.wikipedia.org/wiki/Monetary_conditions_indexhttp://en.wikipedia.org/wiki/Monetary_reformhttp://en.wikipedia.org/wiki/Negative_interest_on_excess_reserveshttp://en.wikipedia.org/wiki/Greenspan_puthttp://en.wikipedia.org/w/index.php?title=Monetary_policy&action=edit&section=22http://en.wikipedia.org/wiki/Monetary_policy#cite_ref-1http://en.wikipedia.org/wiki/Interesthttp://en.wikipedia.org/wiki/Lenderhttp://en.wikipedia.org/wiki/Lenderhttp://en.wikipedia.org/wiki/Percentagehttp://en.wikipedia.org/wiki/Principal_sumhttp://en.wikipedia.org/wiki/Principal_sumhttp://en.wikipedia.org/wiki/Quantitative_easing#Credit_easinghttp://en.wikipedia.org/wiki/Quantitative_easinghttp://en.wikipedia.org/wiki/Signalling_(economics)http://en.wikipedia.org/wiki/Bank_of_Canadahttp://en.wikipedia.org/w/index.php?title=Monetary_policy&action=edit&section=21http://en.wikipedia.org/wiki/Interaction_between_monetary_and_fiscal_policieshttp://en.wikipedia.org/wiki/Interest_on_excess_reserveshttp://en.wikipedia.org/wiki/Macroeconomic_modelhttp://en.wikipedia.org/wiki/Monetary_conditions_indexhttp://en.wikipedia.org/wiki/Monetary_reformhttp://en.wikipedia.org/wiki/Negative_interest_on_excess_reserveshttp://en.wikipedia.org/wiki/Greenspan_puthttp://en.wikipedia.org/w/index.php?title=Monetary_policy&action=edit&section=22http://en.wikipedia.org/wiki/Monetary_policy#cite_ref-1http://en.wikipedia.org/wiki/Interesthttp://en.wikipedia.org/wiki/Lenderhttp://en.wikipedia.org/wiki/Percentagehttp://en.wikipedia.org/wiki/Principal_sum


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o /.2 %utput and unemployment

o /.3 %pen Mar!et %perations in the 0nited tates

o /.$ Money and inflation

4 (mpact on saings and pensions

7 Mathematical note

< Bero interest rate policy

18 egatie interest rates

o 18.1 egatie interest on central ban! reseres

11 ee also

12 otes

13 -eferences

1$ "xternal lin!s

Interest rate notations[edit]

;hat is commonly referred to as the interest ratein the media is generally the rate offered on

oernight deposits by the #entral ?an! or other authority,annualied.[citation needed]

&he total interest on a loan or inestment depends on the timescale the interest is calculated on,

because interest paid may be compounded.

(n retail finance,theannual percentage rateand effectie annual rateconcepts hae been

introduced to help consumers easily compare different products with different payment structures.

(n business and inestment finance, the effectie interest rate is often deried from the yield, a

composite measure which ta!es into account all payments of interest and capital from the

inestment. &he notion of annual effectie discount rate, often called simply the discount rate, is also

used in finance, as an alternatie measure to the effectie annual rate which is more useful or

standard in some contexts. : positie annual effectie discount rate is always a lower number than

the interest rate it represents.

Historical interest rates[edit]
http://en.wikipedia.org/wiki/Interest_rate#Output_and_unemploymenthttp://en.wikipedia.org/wiki/Interest_rate#Open_Market_Operations_in_the_United_Stateshttp://en.wikipedia.org/wiki/Interest_rate#Money_and_inflationhttp://en.wikipedia.org/wiki/Interest_rate#Impact_on_savings_and_pensionshttp://en.wikipedia.org/wiki/Interest_rate#Mathematical_notehttp://en.wikipedia.org/wiki/Interest_rate#Zero_interest_rate_policyhttp://en.wikipedia.org/wiki/Interest_rate#Negative_interest_rateshttp://en.wikipedia.org/wiki/Interest_rate#Negative_interest_on_central_bank_reserveshttp://en.wikipedia.org/wiki/Interest_rate#See_alsohttp://en.wikipedia.org/wiki/Interest_rate#Noteshttp://en.wikipedia.org/wiki/Interest_rate#Referenceshttp://en.wikipedia.org/wiki/Interest_rate#External_linkshttp://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=1http://en.wikipedia.org/wiki/Effective_interest_ratehttp://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Compound_interesthttp://en.wikipedia.org/w/index.php?title=Retail_finance&action=edit&redlink=1http://en.wikipedia.org/w/index.php?title=Retail_finance&action=edit&redlink=1http://en.wikipedia.org/wiki/Annual_percentage_ratehttp://en.wikipedia.org/wiki/Annual_percentage_ratehttp://en.wikipedia.org/wiki/Effective_annual_ratehttp://en.wikipedia.org/wiki/Effective_annual_ratehttp://en.wikipedia.org/wiki/Yield_(finance)http://en.wikipedia.org/wiki/Annual_effective_discount_ratehttp://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=2http://en.wikipedia.org/wiki/Interest_rate#Output_and_unemploymenthttp://en.wikipedia.org/wiki/Interest_rate#Open_Market_Operations_in_the_United_Stateshttp://en.wikipedia.org/wiki/Interest_rate#Money_and_inflationhttp://en.wikipedia.org/wiki/Interest_rate#Impact_on_savings_and_pensionshttp://en.wikipedia.org/wiki/Interest_rate#Mathematical_notehttp://en.wikipedia.org/wiki/Interest_rate#Zero_interest_rate_policyhttp://en.wikipedia.org/wiki/Interest_rate#Negative_interest_rateshttp://en.wikipedia.org/wiki/Interest_rate#Negative_interest_on_central_bank_reserveshttp://en.wikipedia.org/wiki/Interest_rate#See_alsohttp://en.wikipedia.org/wiki/Interest_rate#Noteshttp://en.wikipedia.org/wiki/Interest_rate#Referenceshttp://en.wikipedia.org/wiki/Interest_rate#External_linkshttp://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=1http://en.wikipedia.org/wiki/Effective_interest_ratehttp://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Compound_interesthttp://en.wikipedia.org/w/index.php?title=Retail_finance&action=edit&redlink=1http://en.wikipedia.org/wiki/Annual_percentage_ratehttp://en.wikipedia.org/wiki/Effective_annual_ratehttp://en.wikipedia.org/wiki/Yield_(finance)http://en.wikipedia.org/wiki/Annual_effective_discount_ratehttp://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=2


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'ermany experienced deposit interest rates from 1$L in 1


23/51

Political s&ort'term gain= Eowering interest rates can gie the economy a shortDrun boost.

0nder normal conditions, most economists thin! a cut in interest rates will only gie a short term

gain in economic actiity that will soon be offset by inflation. &he uic! boost can influence

elections. Most economists adocate independent central ban!s to limit the influence of politics

on interest rates.

(e!erred consumption= ;hen money is loaned the lender delays spending the money

on consumptiongoods. ince according to time preferencetheory people prefer goods now to

goods later, in a free mar!et there will be a positie interest rate.

%n!lationary e)pectations= Most economies generally exhibit inflation, meaning a gien

amount of money buys fewer goods in the future than it will now. &he borrower needs to

compensate the lender for this.

*lternative investments= &he lender has a choice between using his money in different

inestments. (f he chooses one, he forgoes the returns from all the others. *ifferent inestments

effectiely compete for funds.

+isks o! investment= &here is always a ris! that the borrower will go ban!rupt, abscond,

die, or otherwise defaulton the loan. &his means that a lender generally charges a ris!

premiumto ensure that, across his inestments, he is compensated for those that fail.

Li,uidity pre!erence= +eople prefer to hae their resources aailable in a form that can

immediately be exchanged, rather than a form that ta!es time to realie.

Ta)es= ?ecause some of the gains from interest may be sub@ect to taxes, the lender may

insist on a higher rate to ma!e up for this loss.

Banks= ?an!s can tend to change the interest rate to either slow down or speed up economy

growth. &his inoles either raising interest rates to slow the economy down, or lowering interest

rates to promote economic growth. [13]

-conomy= (nterest rates can fluctuate according to the status of the economy. (t will

generally be found that if the economy is strong then the interest rates will be high, if the

economy is wea! the interest rates will be low.

Real vs nominal interest rates[edit]

%urt&er information:%is&er e'uation

&he nominal interest rateis the amount, in percentage terms, of interest payable.
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For example, suppose a household deposits R188 with a ban! for 1 year and they receie interest of

R18. :t the end of the year their balance is R118. (n this case, thenominal interest rateis 18L per

annum.

&he real interest rate, which measures the purchasing powerof interest receipts, is calculated by

ad@usting the nominal rate charged to ta!e inflationinto account. 5ee real s. nominal in

economics.6

(f inflation in the economy has been 18L in the year, then the R118 in the account at the end of the

year buys the same amount as the R188 did a year ago. &hereal interest rate, in this case, is ero.

:fter the fact, the ArealiedA real interest rate, which has actually occurred, is gien by the Fisher

euation,and is

where pS the actual inflation rate oer the year. &he linear approximation

is widely used.

&he expected real returns on an inestment, before it is made, are=

where=

S real interest rate

S nominal interest rateS expected or pro@ected inflation oer the year

Market interest rates[edit]

&here is a mar!etfor inestments which ultimately includes the money

mar!et,bond mar!et, stoc! mar!et, and currency mar!etas well as retail

financial institutions li!e ban!s.

"xactly how these mar!ets function are sometimes complicated. )oweer,

economists generally agree that the interest rates yielded by any

inestment ta!e into account=

&he ris!Dfree cost of capital

(nflationary expectations

&he leel of ris! in the inestment
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Most inestors prefer their money to be in cashthan in

lessfungibleinestments. #ash is on hand to be spent

immediately if the need arises, but some inestments

reuire time or effort to transfer into spendable form. &his is

!nown as liuidity preference.: 1Dyear loan, for instance,is ery liuid compared to a 18Dyear loan. : 18Dyear

0&reasury bond, howeer, is liuid because it can easily

be sold on the mar!et.

* market interest'rate model[edit]

: basic interest rate pricing model for an asset

:ssuming perfect information, peis the same for all

participants in the mar!et, and this is identical to=

where

inis the nominal interest rate on a gien inestment

iris the ris!Dfree return to capital

inS the nominal interest rate on a shortDterm ris!Dfree liuid bond 5such as 0.. &reasury?ills6.

rpS a ris! premium reflecting the length of the inestment and the li!elihood the borrowerwill default

lpS liuidity premium 5reflecting the perceied difficulty of conerting the asset into money

and thus into goods6.pread[edit]

&he spreadof interest rates is

the lending rate minus the

deposit rate.[1]&his spread

coers operating costs for

ban!s proiding loans and

deposits. : negatie spreadis

where a deposit rate is higher

than the lending rate.[1/]

Interest rates inmacroeconomics[edit]
http://en.wikipedia.org/wiki/Cashhttp://en.wikipedia.org/wiki/Cashhttp://en.wikipedia.org/wiki/Fungibilityhttp://en.wikipedia.org/wiki/Fungibilityhttp://en.wikipedia.org/wiki/Fungibilityhttp://en.wikipedia.org/wiki/Liquidity_preferencehttp://en.wikipedia.org/wiki/Liquidity_preferencehttp://en.wikipedia.org/wiki/Treasury_bondhttp://en.wikipedia.org/wiki/Treasury_bondhttp://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=10http://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=11http://en.wikipedia.org/wiki/Interest_rate#cite_note-15http://en.wikipedia.org/wiki/Interest_rate#cite_note-15http://en.wikipedia.org/wiki/Interest_rate#cite_note-16http://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=12http://en.wikipedia.org/wiki/Cashhttp://en.wikipedia.org/wiki/Fungibilityhttp://en.wikipedia.org/wiki/Liquidity_preferencehttp://en.wikipedia.org/wiki/Treasury_bondhttp://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=10http://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=11http://en.wikipedia.org/wiki/Interest_rate#cite_note-15http://en.wikipedia.org/wiki/Interest_rate#cite_note-16http://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=12


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-lasticity o!substitution[edit]

&he elasticity of substitution

5full name should be the

marginal rate of substitution of

the relatie allocation6 affects

the real interest rate. &he

larger the magnitude of the

elasticity of substitution, the

more the exchange, and the

lower the real interest rate.

Output andunemployment[edit]

)igher interest rates increase

the cost of borrowing which

can reduce inestment and

output and increase

unemployment. "xpanding

businesses, especially

entrepreneurs tend to be net

debtors. )oweer,

the:ustrian chool of

"conomicssees higher rates

as leading to greater

inestment in order to earn

the interest to pay its

creditors. )igher rates

encourage more saing and

reduce inflation.

Open Market

Operations in t&eUnited tates[edit]
http://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=13http://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=13http://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=14http://en.wikipedia.org/wiki/Austrian_Schoolhttp://en.wikipedia.org/wiki/Austrian_Schoolhttp://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=15http://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=13http://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=14http://en.wikipedia.org/wiki/Austrian_Schoolhttp://en.wikipedia.org/wiki/Austrian_Schoolhttp://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=15


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&he effectie federal funds rate

in the 0 charted oer more

than half a century

&he Federal -esere 5often

referred to as A&he FedA6

implements monetary

policylargely by targeting

the federal funds rate. &his is

the rate that ban!s charge

each other for oernight loans

of federal funds, which are the

reseres held by ban!s at the

Fed. %pen mar!et

operationsare one tool within

monetary policy implemented

by the Federal -esere to

steer shortDterm interest rates

using the power to buy and

sell treasury securities.

Money and

in!lation[edit]Eoans, bonds, and shares

hae some of the

characteristics of money and

are included in thebroad

moneysupply.
http://en.wikipedia.org/wiki/Monetary_policyhttp://en.wikipedia.org/wiki/Monetary_policyhttp://en.wikipedia.org/wiki/Monetary_policyhttp://en.wikipedia.org/wiki/Federal_funds_ratehttp://en.wikipedia.org/wiki/Federal_fundshttp://en.wikipedia.org/wiki/Open_market_operationshttp://en.wikipedia.org/wiki/Open_market_operationshttp://en.wikipedia.org/wiki/Securitieshttp://en.wikipedia.org/wiki/Securitieshttp://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=16http://en.wikipedia.org/wiki/Broad_moneyhttp://en.wikipedia.org/wiki/Broad_moneyhttp://en.wikipedia.org/wiki/Monetary_policyhttp://en.wikipedia.org/wiki/Monetary_policyhttp://en.wikipedia.org/wiki/Federal_funds_ratehttp://en.wikipedia.org/wiki/Federal_fundshttp://en.wikipedia.org/wiki/Open_market_operationshttp://en.wikipedia.org/wiki/Open_market_operationshttp://en.wikipedia.org/wiki/Securitieshttp://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=16http://en.wikipedia.org/wiki/Broad_moneyhttp://en.wikipedia.org/wiki/Broad_money


29/51

?y setting in, the goernment

institution can affect the

mar!ets to alter the total of

loans, bonds and shares

issued. 'enerally spea!ing, ahigher real interest rate

reduces the broad money

supply.

&hrough the uantity theory of

money, increases in the

money supply lead to inflation.

Impact on

savings andpensions[edit]

Financial economistssuch

as;orld +ensions #ouncil

5;+#6researchers hae

argued that durably low

interest rates in most '28

countries will hae an aderse

impact onthe fundingpositions of

pension funds as Pwithout

returns that outstrip inflation,

pension inestors face the

real alue of their saings

declining rather than

ratcheting up oer the next

few yearsQ [14]

From 1


30/51

bonds. &his brought a certain

sense of complacency

amongst some

pension actuarialconsultants

and regulators, ma!ing itseem reasonable to use

optimistic economic

assumptions to calculate

the present alueof future

pension liabilities...

&his potentially longDlasting

collapse in returns

on goernment bondsis

ta!ing place against the

bac!drop of a protracted fall in

returns for other coreDassets

such as blue chip stoc!s, and,

more importantly, a silent

demographic shoc!. Factoring

in the corresponding

longeity ris!, pension

premiums could be raised

significantly whiledisposableincomesstagnate and

employees wor! longer years

before retiring.[14]

Mathematicalnote[edit]

?ecause interest and inflation

are generally gien as

percentage increases, the

formulae aboe are 5linear6

approximations.

For instance,
http://en.wikipedia.org/wiki/Actuarialhttp://en.wikipedia.org/wiki/Regulator_(economics)http://en.wikipedia.org/wiki/Present_valuehttp://en.wikipedia.org/wiki/Government_bondhttp://en.wikipedia.org/wiki/Longevity_riskhttp://en.wikipedia.org/wiki/Disposable_incomehttp://en.wikipedia.org/wiki/Disposable_incomehttp://en.wikipedia.org/wiki/Disposable_incomehttp://en.wikipedia.org/wiki/Interest_rate#cite_note-Reuters-17http://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=18http://en.wikipedia.org/wiki/Linear_approximationhttp://en.wikipedia.org/wiki/Linear_approximationhttp://en.wikipedia.org/wiki/Actuarialhttp://en.wikipedia.org/wiki/Regulator_(economics)http://en.wikipedia.org/wiki/Present_valuehttp://en.wikipedia.org/wiki/Government_bondhttp://en.wikipedia.org/wiki/Longevity_riskhttp://en.wikipedia.org/wiki/Disposable_incomehttp://en.wikipedia.org/wiki/Disposable_incomehttp://en.wikipedia.org/wiki/Interest_rate#cite_note-Reuters-17http://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=18http://en.wikipedia.org/wiki/Linear_approximationhttp://en.wikipedia.org/wiki/Linear_approximation


31/51

is only approximate. (n

reality, the relationship is

so

&he two

approximations,

eliminating higher

order terms, are=

&he formulae

in this article

are exact

iflogarithmic

unitsare

used for

relatie

changes, oreuialently

iflogarithms

of indicesare

used in place

of rates, and

hold een for

large relatie

changes.

Mostelegantly, if

the natural

logarithmis

used, yielding

the neperas

logarithmic
http://en.wikipedia.org/wiki/Higher_order_termshttp://en.wikipedia.org/wiki/Higher_order_termshttp://en.wikipedia.org/wiki/Logarithmic_unithttp://en.wikipedia.org/wiki/Logarithmic_unithttp://en.wikipedia.org/wiki/Logarithmic_unithttp://en.wikipedia.org/wiki/Logarithmic_unithttp://en.wikipedia.org/wiki/Logarithmhttp://en.wikipedia.org/wiki/Logarithmhttp://en.wikipedia.org/wiki/Index_(economics)http://en.wikipedia.org/wiki/Natural_logarithmhttp://en.wikipedia.org/wiki/Natural_logarithmhttp://en.wikipedia.org/wiki/Natural_logarithmhttp://en.wikipedia.org/wiki/Neperhttp://en.wikipedia.org/wiki/Higher_order_termshttp://en.wikipedia.org/wiki/Higher_order_termshttp://en.wikipedia.org/wiki/Logarithmic_unithttp://en.wikipedia.org/wiki/Logarithmic_unithttp://en.wikipedia.org/wiki/Logarithmhttp://en.wikipedia.org/wiki/Index_(economics)http://en.wikipedia.org/wiki/Natural_logarithmhttp://en.wikipedia.org/wiki/Natural_logarithmhttp://en.wikipedia.org/wiki/Neper


32/51


33/51

thisero

lower

boundthe

central ban!

facesdifficulties

with

conentional

monetary

policy,

because it is

generally

belieed that

mar!etinterest rates

cannot

realistically

be pushed

down into

negatie

territory.

Negativeinterestrates[edit]

ominal

interest rates

are normally

positie, but

not always.

'ien the

alternatie of

holding cash,

and thus

earning 8L,
http://en.wikipedia.org/wiki/Zero_lower_bound_problemhttp://en.wikipedia.org/wiki/Zero_lower_bound_problemhttp://en.wikipedia.org/wiki/Zero_lower_bound_problemhttp://en.wikipedia.org/wiki/Zero_lower_bound_problemhttp://en.wikipedia.org/wiki/Zero_lower_bound_problemhttp://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=20http://en.wikipedia.org/wiki/Zero_lower_bound_problemhttp://en.wikipedia.org/wiki/Zero_lower_bound_problemhttp://en.wikipedia.org/wiki/Zero_lower_bound_problemhttp://en.wikipedia.org/w/index.php?title=Interest_rate&action=edit&section=20


34/51

rather than

lending it out,

profitDsee!ing

lenders will

not lendbelow 8L, as

that will

guarantee a

loss, and a

ban! offering

a negatie

deposit rate

will find few

ta!ers, assaers will

instead hold

cash.[17]

*uring

the "uropean

soereignD

debt crisis,

goernment

bonds ofsome

countries

5witerland,

*enmar!,

'ermany,

Finland, the

etherlands

and :ustria6

hae beensold at

negatie

yields.

uggested

explanations

include
http://en.wikipedia.org/wiki/Interest_rate#cite_note-18http://en.wikipedia.org/wiki/European_sovereign-debt_crisishttp://en.wikipedia.org/wiki/European_sovereign-debt_crisishttp://en.wikipedia.org/wiki/European_sovereign-debt_crisishttp://en.wikipedia.org/wiki/Interest_rate#cite_note-18http://en.wikipedia.org/wiki/European_sovereign-debt_crisishttp://en.wikipedia.org/wiki/European_sovereign-debt_crisishttp://en.wikipedia.org/wiki/European_sovereign-debt_crisis


35/51

desire for

safety and

protection

against the

euroonebrea!ing up

5in which

case some

euroone

countries

might

redenominate

their debt into

a strongercurrency6.[1


36/51


37/51

by ilio

'esell.[23]:

negatie

interest rate

can bedescribed 5as

by 'esell6 as

a tax on

holding

money> he

proposed it

as

the %reigeld5f

ree money6component of

his%reiirtsc

&aft5free

economy6

system. &o

preent

people from

holding cash

5and thus

earning 8L6,

'esell

suggested

issuing

money for a

limited

duration,

after which it

must be

exchanged

for new bills>

attempts to

hold money

thus result in

it expiring
http://en.wikipedia.org/wiki/Silvio_Gesellhttp://en.wikipedia.org/wiki/Silvio_Gesellhttp://en.wikipedia.org/wiki/Interest_rate#cite_note-mankiw-23http://en.wikipedia.org/wiki/Freigeldhttp://en.wikipedia.org/wiki/Freiwirtschafthttp://en.wikipedia.org/wiki/Freiwirtschafthttp://en.wikipedia.org/wiki/Freiwirtschafthttp://en.wikipedia.org/wiki/Silvio_Gesellhttp://en.wikipedia.org/wiki/Silvio_Gesellhttp://en.wikipedia.org/wiki/Interest_rate#cite_note-mankiw-23http://en.wikipedia.org/wiki/Freigeldhttp://en.wikipedia.org/wiki/Freiwirtschafthttp://en.wikipedia.org/wiki/Freiwirtschaft


38/51

and

becoming

worthless.

:long similar

lines,CohnMaynard

eynesappr

oingly cited

the idea of a

carrying tax

on money,

[23]51


39/51

based on

how long the

bill had been

held.[2$]

(t has been

proposed that

a negatie

interest rate

can in

principle be

leied on

existing

paper

currency ia

a serial

numberlotter

y= choosing a

random

number 8 to

< and

declaring that

bills whose

serial numberend in that

digit are

worthless

would yield a

negatie 18L

interest rate,

for instance

5choosing the

last two digitswould allow a

negatie 1L

interest rate,

and so forth6.

&his was

proposed by
http://en.wikipedia.org/wiki/Interest_rate#cite_note-wired-24http://en.wikipedia.org/wiki/Serial_numberhttp://en.wikipedia.org/wiki/Serial_numberhttp://en.wikipedia.org/wiki/Interest_rate#cite_note-wired-24http://en.wikipedia.org/wiki/Serial_numberhttp://en.wikipedia.org/wiki/Serial_number


40/51

an

anonymous

student of .

'regory

Man!iw,[23]

though more as

a thought

experiment

than a

genuine

proposal.[2]

: much

simpler

method to

achiee

negatie real

interest rates

and proide a

disincentie

to holding

cash, is for

goernments

to encouragemildly

inflationary

monetary

policy>

indeed, this is

what eynes

recommende

d bac! in

1


41/51

reserves[edit]

Main

article: .egat

ie interest

on e/cess

reseres

)oweer,

central ban!

rates can, in

fact, be

negatie.

#ountries

such asweden and

*enmar!

hae set

negatie

interest on

reseresO

that is to say,

they hae

chargedinterest on

reseres.[2/][24]

[27][2


42/51

setting its

oernight

deposit rate

at D8.2L.

[38]

&heexistence of

the negatie

oernight

deposit rate

was a

technical

conseuence

of the fact

that oernightdeposit rates

are generally

set at 8.L

below or

8.4L below

the policy

rate.[38][31]&his

is not

technically an

example of

negatie

interest on

excess

reseres,

because

weden does

not hae a

resere

reuirement,

[32]but

imposing a

resere

interest rate

without
http://en.wikipedia.org/wiki/Interest_rate#cite_note-sweden-negative-repo-table-30http://en.wikipedia.org/wiki/Interest_rate#cite_note-sweden-negative-repo-table-30http://en.wikipedia.org/wiki/Interest_rate#cite_note-sweden-negative-repo-table-30http://en.wikipedia.org/wiki/Interest_rate#cite_note-:0-31http://en.wikipedia.org/wiki/Interest_rate#cite_note-32http://en.wikipedia.org/wiki/Interest_rate#cite_note-32http://en.wikipedia.org/wiki/Interest_rate#cite_note-sweden-negative-repo-table-30http://en.wikipedia.org/wiki/Interest_rate#cite_note-sweden-negative-repo-table-30http://en.wikipedia.org/wiki/Interest_rate#cite_note-:0-31http://en.wikipedia.org/wiki/Interest_rate#cite_note-32


43/51


44/51

#onsider this example= ;i!i;orld #o. had the following inentory at hand, in order of acuisition in

oember=

/umber o! Units $ost

188 units R8

12 units R

4 units RRR0 a$ounted to as$uch as Rs!!,.5 bi&&ion. -he 9e biggest co$$ercia& ban/s a&one $aintainede7cess cash reseres of Rs3., bi&&ion on a dai&y basis oer the sa$e )eriod.

8n a )ress re&ease &ast +ee/( the SBP said the ai$ of &iquidity injection +as not tobene9t ban/s. >a&&ing this inter)retation of successie OMOs )artia& ana&ysis of$onetary ariab&es(0 it said the &iquidity crunch in the interban/ $ar/et is)ri$ari&y a function of negatie goern$ent borro+ings fro$ the centra& ban/.

%s o))osed to Mar/et -reasury Bi&&s that resu&t in goern$ent borro+ings fro$

schedu&ed ban/s( this is the debt that the goern$ent had raised throughMar/et Re&ated -reasury Bi&&s ?MR-Bs@. -hus( its retire$ent $eans that thegoern$ent is suc/ing &iquidity out of the syste$ at a $assie &ee& and )uttingit bac/ into the hands of the centra& ban/.

-he goern$ent retired Rs3!5. bi&&ion of its debt fro$ the centra& ban/ during'u&y ! and 1ece$ber 26. 8n contrast( goern$ent borro+ings fro$ the SBP hadtota&&ed RsA bi&&ion in the co$)arab&e )eriod of the )receding 9sca& year(oCcia& data sho+s.

Moreoer( goern$ent borro+ings fro$ schedu&ed ban/s are a&so creating

de$and for further &iquidity in the syste$. -hey a$ounted to Rs66. bi&&ionunti& 1ece$ber 26 as o))osed to the retire$ent of Rs. bi&&ion during thesa$e )eriod of 2!3!.

Published in The Express Tribune, January 20th, 2015.

Like Business on Faebook( !ollo" #TribuneBi$on T"itter to stay in!or%ed and&oin in the on'ersation.

T1- term 2circular debt3 in t&e po4er sector is 4idely understood in t&e countryas representing an issue 4&ose solution &as eluded policymakers !or t&e last

t&ree years.T&is article attempts to e)plain t&e genesis o! t&e problem and 4ays

to resolve it.

#ircular debt arises when one party not haing adeuate cash flows to discharge its

obligations to its suppliers withholds payments. ;hen it does so, the problem affects
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49/51

other entities in the supply chain, each of which withholds its payments, resulting in

operational difficulties for all serice proiders in the sector, none of whom are then able

to function at full capacity, causing unnecessary loadshedding.

&he circular debt numbers that get reported in the press tend to be the sum of the

receiables of each organisation which ends up exaggerating the amount, simplybecause of double counting. :fter all, one partyTs payables are the other partyTs

receiables, and logically these should cancel out when we subtract one from the other.

:t worst the net amount should be much smaller.

(n our case, howeer, een this net unad@usted amount on Cune 38, 2811 was in excess

of -s288bn, which this year is growing by -s in their case there can be no debt beyond

the terms agreed for the supply of oil.

&he oil mar!eting companies sell oil to the (++s or the ;apdaDowned electricitygeneration plants 5called 'encos6 which produce electricity and sell it to the

goernmentDrun distribution companies referred to as *(#%s 5for example Eesco,

+esco, etc6 which proide power to our homes and factories and bill us for this serice.

&he tariff 5price6 at which the 'encos sell to the *(#%s and the tariff at which

electricity is supplied to us consumers is determined by epra, after receiing

goernment approal.

&he first problem which results in the receiables not cancelling out payables is whenthe tariff is unable to meet the costs of its generation and distribution. For instance, if

the price of oil goes up internationally and tariffs are not reised upwards to account for

this increase, there is an element of subsidy whose cost the goernment has to pic! up.

o one component of what constitutes circular debt is the lower rate at which electricity

is being charged to the consumer than the cost of its generation and distribution. ?y

failing to foot this subsidy bill the goernment builds up the circular debt. &he bul! of the

issue arising from the failure to reise tariffs upwards on a timely basis has beenresoled> the remaining ad@ustment reuired on this account is -s188bn for this year,

which also includes the cost of poor goernance.

ext, three components, and the most critical ones, which raise costs, and feed the

circular debt, are the following=


50/51

O &he inefficiencies of goernmentDowned generation and distribution companies, cosy

deals struc! with proiders of rental power plants, oerstaffing, free proision of

electricity to ;apda employees 5this costs other consumers -s18 crore a day6, poor

maintenance of plant euipment, obsolete technologies 5resulting in technical losses6,corruption, all of which simply add to the cost of electricity that consumers are being

constrained to bear with euanimity through tariff increases.

O &he massie issue of electricity theft O the cases of *(#%s in )yderabad,

+eshawar, Wuetta and Fata are now well !nown> with literally no one paying in Fata.

O +oor collection of electricity bills. -spreent electricity theft> and ensure collection of billings speedily and disconnecting

those not paying their bills> disconnections will actually also reduce the extent of

outagesHloadshedding. (n other words, the principle issue is that of goernance.

o what is the solutionX &he liabilities in the shape of the inherited Vstoc!T of -s288bn

can be cleared as a oneDtime effort O een, dare ( say it, Vthrough printing of moneyT5the latter admittedly at the expense of a slightly higher rate of inflation6 proided, and

this would be the ma@or caeat, we ta!e firm and clear initiaties that will preent the

buildDup of the circular debt again. ( highlight this because the preailing incentie

structures enable those operating the sector to lie with the comfortable feeling of

business as usual 5with the same leel of incompetence and degree of poorgoernance6, coninced that the goernment will simply step forward, yet again, a few

months down the road to bail out them out.

From these arguments and facts, it should be fairly obious that the recent decision of

the goernment to priatise the management of the 'encos not @ust betrays a wea!

diagnosis of the problem of circular debt but also oerloo!s the urgency to ensure

continued proision of reliable power so that the economy remains a growing concernO the inefficiencies of 'encos is a relatiely minor issue. &he principle issue is poor

goernance, reflected in the sheer failure to wea!en the control of powerful lobbies who

continue to ride this gray train while the rest of the population wrings its handshelplessly.

(t is difficult to fathom how priatising management of generation companies can sole

the problem if electricity tariffs are not raised in a timely manner and goernmentDmanaged *(#%s fail to preent electricity theft or collect their bills regularly and


51/51

disconnect those not paying their bills i.e. ta!e actions that will ensure cash flows to pay

'encos and suppliers of fuel regularly.

Moreoer, with existing (++s already issuing notices to the goernment that either their

dues be paid or they will wind up their operation, it would not be a good adertisement

for any entrepreneur seriously contemplating such an inestment, unless he is foolhardyor !nows something we donTt O the latter could be a situation in which he will get paid a

minimum capacity payment without haing to run the plant in the express !nowledge

that fuel, especially gas, would not be supplied.

(n other words, we could @ust end up facilitating a scam, with a goernment liability being

created in the shape of a capacity payment which neer had to be discharged while the

generation company was owned by ;apda.

o the correct solution is to either immediately priatise the management or ownership

of *(#%s 5under an appropriate regulatory framewor!6 or hand them oer to theproincial goernments. &he electricity can be supplied at the proincial borders for the

proincial goernments to purchase it from the 'encos and manage the *(#%s,

thereby relieing (slamabadTs oerstretched budget from the burden of this seemingly

neerDending electricity subsidy.

+&e riter as formerl! goernor of t&e tate an3 of a3istan5

monetary policy and interest rate

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