Exam 5: The Determinants of Interest Rates: Competing Ideas

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This view of interest rates and asset prices assumes that the money and capital markets are highly efficient in the use of information in determining the public's expectations regarding future changes in interest rates and asset prices. Equilibrium interest rates impound all relevant information very quickly and change only when relevant new information appears. Forecasting market interest rates is presumed to be virtually impossible on a consistent basis because interest-rate forecasters must know (1) what market participants expect to happen and (2) what new information will arrive in the market before that information actually arrives.

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Keynes observed that the public demands money for three different purposes (motives). The transactions motive represents the demand for money (cash balances) to purchase goods and services. Because inflows and outflows of money are not perfectly synchronized in either timing or amount and because it is costly to shift back and forth between money and other assets, businesses, households and governments must keep some cash in the till or in demand accounts simply to meet daily expenses. Some money also must be held as a reserve for future emergencies and to cover extraordinary expenses. This precautionary motive arises because we live in a world of uncertainty and cannot predict exactly what expenses or investment opportunities will arise in the future.
Keynes assumed that money demanded for transactions and precautionary purposes is dependent on the level of national income, business sales and prices. Reflecting money's role as a medium of exchange, higher levels of income, sales orprices increase the need for cash balances to carry out transactions and to respond to future opportunities. However, neither the precautionary nor the transactions demand for money was assumed to be affected by changes in interest rates. In fact, Keynes assumed money demand for precautionary and transactions purposes to be fixed in the short term. In the longer term, however, transactions and precautionary demands change as income changes.
Short-term changes in interest rates were attributed by Keynes to a third motive for holding money or cash balances--the speculative motive--that stems from uncertainty about the future prices of bonds.

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The liquidity preference theory is a short-term approach to interest rate determination unless modified because it assumes that in-come remains stable. In the longer term, interest rates are affected by changes in the level of income and by inflationary expectations. Indeed, it is impossible to have a stable equilibrium interest rate without also reaching an equilibrium level of income, saving and investment in the economy. Also, liquidity preference considers only the supply and demand for the stock of money, whereas business, consumer and government demands for credit clearly have an impact on the cost of credit. A more comprehensive view of interest rates is needed that considers the important roles played by all actors in the financial system: businesses, households and governments.