Determinants Of The Level Of Interest Rates

Interest rates and forecasts of their future values are among the most important inputs into an investment decision. For example, suppose you have $10,000 in a savings account. The bank pays you a variable interest rate tied to some short-term reference rate such as the 30-day Treasury bill rate. You have the option of moving some or all of your money into a longer-term certificate of deposit that offers a fixed rate over the term of the deposit.

Your decision depends critically on your outlook for interest rates. If you think rates will fall, you will want to lock in the current higher rates by investing in a relatively long-term CD. If you expect rates to rise, you will want to postpone committing any funds to long-term CDs.

Forecasting interest rates is one of the most notoriously difficult parts of applied macroeconomics. Nonetheless, we do have a good understanding of the fundamental factors that determine the level of interest rates:

1. The supply of funds from savers, primarily households.

2. The demand for funds from businesses to be used to finance investments in plant, equipment, and inventories (real assets or capital formation).

3. The government's net supply and/or demand for funds as modified by actions of the Federal Reserve Bank.

Before we elaborate on these forces and resultant interest rates, we need to distinguish real from nominal interest rates.

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