BEE Partner, South Africa Economy Watch

The endogenous determination of the interest rate

In a boom, banks will lend more and will seek to create new deposits or issue additional notes. To support these activities, they will have to attract additional reserves. This will lead them to bid up interest rates, as they seek to attract idle reserves from one another and from hoards. In a slump, they will issue less and lend less, and will seek to shed reserves, lowering interest rates. In other words, while long-term average rates are determined by costs and competition, current interest rates reflect the balance of supply and demand in the market. They move pro-cyclically.

This is illustrated by a simple model. On the one hand, the rate of interest (in relation to the rate of profit), is likely to affect investment inversely, and investment, in turn, will have an impact on prices and employment. Changes in prices and employment will call for changes in reserves. Read the rest of this entry »

The government budget tends to move counter-cyclically. In a slump, incomes will be reduced and spending curtailed, so tax collections will fall, but welfare and related spending to support the unemployed will tend to rise. Other government budget items are likely to be unaffected. Hence, the overall effect will be to throw the budget into deficit. By contrast, in a boom, tax collections will rise and welfare spending will tend to decline, so a surplus will tend to emerge. In short, in an economy with demand-based cyclical fluctuations, the central government budget will tend to move in a counter-cyclical fashion.

Now consider the monetary implications of deficits and surpluses. A deficit arises when the government spends more than it receives in taxes; this means a net increase in money in the system. Such money will appear as excess reserves in the banking system. If allowed to remain, it will drive down interest rates. Looked at another way, it will drive up security prices. A surplus is just the opposite; it arises when the government spends less than it takes in, and it creates a reserve deficiency, tending to force interest rates up. Read the rest of this entry »