Instituto Cultural Minerva

IBI - Institute of Brazilian Business and Public Management Issues

The George Washington University

This paper also focuses on comments by Mr. William J. McDonough, president of the Federal Reserve Bank of New York, about price stability, what for, what is, and how to achieve it.

According to the Classical theory of interest rates, the money supply does not affect interest rates. This theory considers that the interest rate determinants are business investment and savings by individuals.

The demand for money comes from the business that compares the rate of return on their investments with the interest rate. If the expected return of the investment is bigger than the interest rate, the money is borrowed; if it is smaller, the borrowing is not made.

The countless investments made in the economy have different rates of return. If they were sorted in decreasing order and cumulative amounts, it would be possible to draw a graphic showing the rates of return versus a cumulative amount invested. This curve that has a downward slope is called MARGINAL EFFICIENCY OF CAPITAL, or MEI. The Classical theory assumes that all business investment is debt financed with no equity financing, what is far different from what occurs in reality.

Saving by individuals is the other factor determining interest rates in the Classical theory. According to this view, interest payments represent a compensation to savers for postponing consumption. It means that consumers want to be compensated by more consumption in the future, if thay have to give up consumption now. This idea means that, in the classical vision, with higher interest rates individuals tend to save more. A graphical representation of this theory will show a curve, labeled as S, with an upward slope.

A desequilibrium condition will appear, if investment does not equal saving. Supposing that the interest rate is below the equilibrium level, more investment will be made. With lower rates, individuals will save less, reducing the supply of money, which, thus, will drive up the interest rate back to the equilibrium point.

This approach considers that the interest rate is determined by the supply of and the demand for loanable funds. The demand curve has an downward slope, indicating that a lower interest rate will cause a greater private demand for loanable funds, that, afterward, will decrease with a higher interest rate. The supply curve has an upward slope, because with higher interest rates more funds are supplied to the market. The point where the two curves cross determines the interest rate and the amount of funds transacted.

In the supply side, the classical view assumes that individuals are the only supplier of savings. In the loanable funds approach is included saving from businesses and increases in the money supply, including the rest of the world, also, as source of funds.

The demand for funds is formed by individuals borrowing for consumption; business investments in plants and equipment; and government deficits. It is important to make some considerations about the assumed downward slope of the demand curve for funds.

Consumer borrowing for expensive items, as house or car, can be considered interest-rate sensitive, allowing us to consider that the curve has really a downward slope. For other inexpensive items, such as credit card debt, though, the curve's slope is not clear. But for the total consumption of individuals is much probably downward slope.

Government borrowings in order to match budget deficit is probably not affected by the interest rates level, at least when they are not very high. Sometimes is politically difficult to cut government's expending, or to raise taxes, in order to reduce budget deficit. Apart from this, a higher interest rate implies in more government expending on interest rates, due to previous debt.

The demand for funds by business investors, in the loanable funds approach, is based in the marginal efficiency of capital, that had already been discussed by the classical theory.

The funds supplied to the market include savings from individual consumers, business savings, and increases in money supply. The supply curve is drawn with an upward slope, suggesting that higher interest rates lead to more supply of funds. Yet, there is also debates upon the upward slope of the supply of funds in the loanable funds theory.

First of all, considering that consumers save out of current income for future consumption, the amount of individual saving depends more upon preferences, current income, and wealth than upon interest rates.

The impact of the interest rate is not entirely clear in business savings. Business savings represent retained earnings and depreciation. The latter is a function of usage and accounting rules, and is probably not affected by interest rates.

In retained earnings, the impact of interest rates is ambiguous. Retained earnings equal earnings minus dividends and so, is difficult to realize what is the impact of interest rates on it. In a bank, for instance, interest rates have a bigger impact than in other firms.

The interest rates level probably does not affect the government savings, as it was already analyzed in the demand for funds side.

The major player on the money supply is the Federal Reserve, as it will be further analyzed, that largely acts according to its own monetary police, affecting directly the interest rate level.

Another supply source of funds is the foreign sector, that could provide funds for the economy. In this case, an important influence is the difference from domestic to external interest rates. If the domestic interest rate is bigger than the average of international interest rates, there would be an international capital inflow, increasing the supply of money. The expectations of relative changes in exchange rates and country risk factors also influence the international capital movement.

The money supply is considered in the monetarist view of macroeconomics as the major factor determining the course of the economy. This view includes three areas: the old quantity theory, the classical quantity theory, and the modern quantity theory.

In the past, when only coins made out of precious metals were considered money, it was observed that large increase of the supply of precious metals was followed by increase in price levels. This argument came to be known as the quantity theory of money.

With the financial systems increasing complexity by the nineteenth century, money was no longer restricted to coins but included paper currency and checking deposits. So, a more sophisticated quantity theory was developed.

Beginning with the equation of exchange:

In this equation, the total amount spent in a year is M.V, what is equivalent to the amount of money (M) times the velocity of money, or the number of times money turns over (V). The total amount spent in a year also equals the price level (P) times the level of real (or physical) output (Q).

The equation of exchange can be approximately expressed in terms of rates of change, as:

According to the classical quantity theory, velocity is constant, meaning that v = 0, and implying that:

Solving the equation for the inflation rate, we will have:

In other words, the rate of growth in the money supply must equal the rate of growth in real output, in order to do not have inflation.

THE MODERN QUANTITY THEORY

In the modern quantity theory, the money supply is the most important determinant of GDP.

Second, most modern monetarists believe in strict rules for government economic policy than wide discretion. According to this view, government should estimate economy's long-run a real sustainable growth rate and set money supply equal to it.

Third, modern monetarists also feel that changes in money supply have a wide-ranging impact upon the economy, affecting holdings of all assets, not just bonds.

Fourth, in the monetarist framework, increases in money supply have three impacts, which may be offsetting. First, the added money tends to bid prices of bonds up and interest rates down. Then the increase in money supply tends to stimulate output and this puts upwards pressure on interest rates. Finally, changes in money supply affect inflationary expectations. If bond holders fear a rapid growth in money supply with resulting inflation, an inflationary premium is added onto the interest rate. In the modern monetarist view, an increase in money supply may result in a net increase in interest rates, if inflationary expectations are raised sufficiently.

The continual increase in the general price level is called INFLATION. Individuals try to protect their purchasing power, as prices go up, taking actions that inadvertently contribute to "feed" the inflation, boosting and tending to perpetuate the increase in general price level. Generally, inflation has a significant impact upon economic activity, including interest rates.

The precise measurement of inflation is very difficult. In extreme, each person has its own inflation rate, according to the price fluctuation of its own goods and services consumption. Even when a consumption average is made, there are problems. Basket of goods and services varies according to person's wealth. For instance, the share of basic goods, as food, in Poor's household basic goods consumption is higher than in the richest's. Therefore, changes in basic goods prices affect much more the inflation on economy's poorest side, distorting the inflation of the wealthy society part.

Another problem with inflation measurement is due to changes that happen in time within the basket goods and services consumption. Individuals vary their preferences according to price, preferences, trends, etc. These alterations are not easily captured by the bureaus of statistics.

If a lender has a complete certainty of a future inflation, this expectation will be added as an interest rate premium, to compensate the lender for declining future purchasing power.

It's possible to calculate the increase in interest rate level stemmed from expected inflation. In order to compensate lenders exactly for the declining purchasing power of money, in a tax-free condition, the following condition must hold:

Where: i is the nominal interest rate asked by the lender; r is the real interest rate, defined as the rate that would prevail in an inflation-free world; p is the inflation rate; and r.p represents the interest rate over the inflation rate, that has to be compensated. What makes the nominal interest rate bigger than real interest rate is the amount of expected inflation.

If the government tax the interest income with a rate t, then nominal interest rate must be increased to compensate the lender for taxes paid. That is 1 plus the after-tax yield to maturity should equal (1 + r)(1 + p). In equation form, we will have:

or,

Where: i is the before-tax nominal; r / (1 - t), is the before tax real return; and (p + r.p) / (1 - t) is the before-tax inflation premium. With government's positive tax, nominal interest rate grow even more.

The Neo-Keynesian Model is a revised and improved version of the original Keynesian Model, developed by Jonh Maynard Keynes, in the 1930's. In the neo-Keynesian approach, interest rates are affected by several interrelated factors, as:

The overinvestment of resources in the financial sector is nonproductive, and, thus, brings negative effects onto the economy. During high inflation periods, there is a boost in the amount of banks and branches. The financial system becomes bigger than it would be in a low inflation economy. This inflated financial system diverts resources from the economy, reducing its productivity.

When an economy moves from huge inflation toward low inflation, the financial system has to be reduced, due to the removal of the distorted incentive B inflation. What occurs is business failures and unemployment. The avoidance of such unnecessary, and costly, boom-bust cycles is possible only in a low-inflation environment.

Mr. McDonough ads that: "What monetary policy can do is to anchor inflation at low price levels over the long term and thereby lock in inflation expectations. In addition, monetary policy can help offset the effects of financial crises as well as prevent extreme downturns in the economy." This comment is based upon the fact that policymakers and economists, during the past twenty years, are agreeing "that an active monetary policy to stimulate output and reduce unemployment beyond its sustainable level leads to higher inflation but not to lower unemployment or higher output." In fact, economic growth is originated from expansion in the supply of capital and labor and the productivity with which labor and capital are used, and they are not directly influenced by monetary policy. "However, without doubt, monetary policy can help foster economic growth by ensuring a stable price environment', according to McDonought.

He also emphasizes that: "Allowing even a low level of inflation to persist without a commitment to bring that level downward toward price stability permits B and they even encourage B expectations for still sharper price rises in the future. Such expectations provide an opening for a demand-driven burst of inflation".

McDonough considers that "a central bank must look at a broad array of economic indicators that reflect demand pressures and supply developments in the economy." However, monetary policy can and must also maintain the broad environment for sustainable economic growth, while its one explicit goal must be price stability.

The question is, in practical terms, what does price stability means over both the intermediate and the long term? As currently measured, price stability is not equal to a zero inflation rate. "This is because of well-known errors in measuring inflation that stem from many factors, including how quality improvements and new products are valued in the consumer price index... In most studies, the error has been estimated to range from 0.5% to 2.0%", says McDonough.

The problem of a monetary policy is that inflation is harmful to the economy, and so is a deflation. "The worst financial crises in our history have been associated with deflationary periods. Therefore, were we to set a numerical inflation goal for monetary policy, I believe that an appropriate number for this goal should be within the reasonable range of measurement error B but in the upper end of the range because of the dangers of deflation. Such a numerical goal could be understood as the premium needed to prevent the economy from being tipped toward deflation or needlessly forgoing output," states McDonough.

The central bank will have an easier time reaching its goals if public understands them and believes that the Federal Reserve will take the steps necessary to reach these goals. A believable anti-inflation policy, for instance, implemented through a deceleration of aggregate demand, will more quickly lead the public to expect lower inflation, and such expectation will itself help bring down inflation. In that case, workers will not feel the need to demand large wage increases to protect themselves against expected price hikes B due to higher real wages lead to higher unemployment B, and business will be less aggressive in raising their prices, because it would have losses in sales. In these circumstances, inflation will come down more or less in line with the slowing of aggregate demand, with much less slack emerging in resource markets than if workers and businesses continued to act as if inflation were not going to slow.

A main question to the Federal Reserve is how to achieve the monetary policy goals that are spelled out in law. The actions taken in the reserves market affect the economy with considerable lags. If the Federal Reserve waits to adjust rates until it sees an undesirable change in employment or prices, it will be too late to achieve its objectives. Consequently, the Federal Reserve has to pay attention to guides to policy that are intermediate between operations in the reserves market and effects in the economy. Among those frequently mentioned are monetary and credit aggregates, interest rates, and the foreign exchange value of the dollar.

The Humphrey-Hawkins Act has something to say about the guides for monetary policy. It specifies that each February the Federal Reserve must announce publicly its objectives for growth in money and credit and that at midyear it must review its objectives and revise them if appropriate. This provision of the act was based on the presumption of a reasonably stable relation between growth of money and credit, on the one hand, and the goals of monetary policy, on the other B a relation that could be fruitfully exploited in achieving those goals. Control over the money stock, it was thought, could in effect anchor the price level in much the same way that the former gold standard what thought to have anchored the price level.

Nonetheless, the law foresaw that revision might be appropriate should, for example, the relation between the monetary or credit aggregates and the economy B the velocity of money or credit B change unpredictably. In these circumstances, adherence to the initial objectives for money or credit growth would lead to an undesirable outcome for output or prices. The Federal Reserve is not required to achieve its announced objectives for these financial aggregates, but if it does not, it must explain the reasons to Congress and the public.

The usefulness of the monetary aggregates for indicating the state of the economy and for stabilizing price level has been called into question by frequent departures of their velocities from historical patterns.

The velocity of M2 had, until recently, been fairly stable over long periods, although it did vary over shorter periods in ways related to the interest-rate cycle. In the early 1990's, the velocity of M2 departed from this pattern and drifted upward. This upward drift occurred even as market interest rates were moving down, a change that should have added to the attractiveness of deposits in M2 and lowered its velocity. Such departures from historical experience have made forecasting velocity, and thus the rate of monetary growth needed to achieve economic objectives, more difficult.

The growing variety of new financial assets offered to the public, such as new kinds of mutual funds and mutual funds services, and changes in the way people manage their financial portfolios are been considered the responsible for this unusual monetary behavior. Some analysts expect that rapid financial change will continue and will further undermine the value of the monetary aggregates as guides to policy. On the other hand, others expect the process to settle down as people complete their shifts of investment-type balances to assets outside M2. In this view, once the shift is fairly complete, M2 B perhaps measured somewhat differently B will again behave in reliable way and can again be used effectively as a guide for monetary policy.

Contrasting the Federal Reserve Bank of New York president B perhaps the most important of the Federal Reserve System B, Mr. William J. McDonough, comments with what was written about inflation rate theory is possible to infer some observations.

The Federal Reserve doesn't follow, strictly, any of the interest rates theories. As the major determinant of money supply, the Federal Reserve has the power to set interest rates in its desirable level, according to its own monetary policy goals.

As Mr. McDonough defends price stability as the main goal of monetary policy, this idea clashes with the modern monetarists that state a money supply equal to an estimated economy's long-run real growth rate, as monetary policy.

With the Neo-Keynesian theory of government spending helping economic growth B in other terms, an active monetary policy to induce bigger output B there is a complete difference on monetary policy development role.

In Mr. McDonough' words: "Over the past twenty years, there has been an emerging consensus among policymakers and economists that an active monetary policy to stimulate output and reduce unemployment beyond its sustainable level leads to higher inflation but not to lower unemployment or higher output. ... And what monetary policy cannot do, in and of itself, is produce economic growth." Besides, bounds monetary policy to "help foster economic growth by ensuring a stable price environmental".

Reading carefully Mr. McDonough words about indicators of future inflation: "a central bank must look at a broad array of economic indicators that reflect demand pressures and supply developments in the economy. Unfortunately, there is no single summary measure that provides a reliable overall assessment of the many complex and diverse influences on inflation, which makes it more difficult within most countries to reach a national consensus on policy at any point."

But which are the economic indicators that reflect demand pressures and supply developments in the economy, so to determine the major factors influencing American interest rates? M2, that had a large influence in the past, had departed from its pattern, what made its importance decrease.

However, if economic growth is originated from expansion in the supply of capital and labor and, also, the productivity with which labor and capital are used, the indicators of economic growth and the ones that helps measure capital, labor, and productivity increase are important.

Brazilian international accounts still depend on foreign financial capital inflow, though net direct investments have been rising during the last four years. In order to continue to receive hard currency, the Central Bank of Brazil has to establish the domestic interest rate in a level equal to international interest rates plus a premium, that depends on the Brazilian country risk.

As the world's biggest economy is the United States, the interest rates practiced in that country exert huge influence on international capital flows. U.S interest rates are linked to the Federal Funds interest rate of the Federal Reserve System. So, it is important for the Central Bank of Brazil to keep track of the behavior of this important reference to the Brazilian economy, i.e., the Federal Funds.

Jansen, D. W. et allie, "Intermediate Macroeconomics," West Publishing Company, MN, 1994.

McDonough, W. J., "A Framework for the Pursuit of Price Stability," Federal Reserve Bank of New York Economic Policy Review, NY, 1997.