# What Should We Teach Our Students about Interest Rates Determination

## Article excerpt

ABSTRACT

Introductory macroeconomics textbooks determine interest rates either by liquidity-preference, or loanable-funds approaches, or both. Instructors face problems explaining the effects of fiscal policy when only liquidity-preference approach is introduced, whereas impacts of monetary policy are difficult to explain if only loanable-funds approach is used for interest rates determination. Some authors introduce both the approaches at two different places and use them for different purposes. Students wonder why they need to use two models to explain one concept. Other authors struggle to reconcile, but fail to show how the two approaches lead to the same interest rate. By redefining the concept of the supply of loanable-funds in the light of excess reserves, we present our model of interest rates determination that is capable of tracing the impact of both monetary and fiscal policies on short- and long-run nominal and real interest rates together with the dynamics of it adjustments. Our model is also capable of explaining the effects of changes in required reserve ratio or discount rate on the interest rates. We believe that our model will greatly help the students to understand the concept of interest rates determination better.

JEL Classification Codes:

A22 - Economic Education and Teaching of Economics (Undergraduate)

E43 - Macroeconomics & Monetary Economics (Interest Rates: Determination, Term Structure, and Effects)

INTRODUCTION

In the standard macroeconomics principles textbooks, some authors present only the liquidity-preference (LP) approach, others present only the loanable-funds (LF) approach, and the rest present both the approaches to the modeling of interest rates (r). The LP approach determines the nominal r in the money market where the equilibrium nominal r is the rate that equates quantity of nominal money supplied (M) by the central bank with quantity of nominal money demanded by the public. Among the textbooks we examined, Baumöl and Blinder (1999), Boyes and Melvin (2011), McEachern (1997), O'Sullivan, Sheffrin and Perez (2010), and Schiller (2010) belong to this group, who use only the LP approach to determine equilibrium r. The LF approach, on the other hand, determines the real r in the LF market where the equilibrium real r is the rate that equates the quantity supplied of LF, which consists of private saving (S), with the quantity demanded for LF, which consists of investment (I) and bond financed government deficit (G - T). Instead of viewing budget deficit (G - T) as a part of the demand for LF, some authors prefer to view it as negative amount of government saving, and incorporate that in the supply of LF. Needless to say, the conclusions drawn from these two different representations are identical. Cowen and Tabarrok (2010) are the authors who use only the LF approach for equilibrium r determination. The rest of the authors we examined use both the approaches to explain equilibrium r; however, the presentation of the two approaches differs significantly among these authors. Bade and Parkin (2011), Frank and Bernanke (2009), Hall and Lieberman (2005), Hubbard and O'Brien (2010), Mankiw (2007), Miller (201 1), and Sexton (2002) keep the two approaches completely separate. They use the LP approach to determine the short-run nominal r, and the LF approach to determine the long-run real r without showing any relationship between them. Colander (2010), Gwartney, Stroup, Sobel, and Macpherson (2009), Krugman and Wells (2009) and Parkin (2010), on the other hand, put the LF and the LP diagrams side-by-side in order to reconcile the two approaches. Since often there is a close connection between movement in the short-run nominal r and the long-run real r, these authors assume zero inflation expectation to make the real r the same as the nominal r. Since the choice of approach to explain equilibrium real and nominal r in the short- and in the long-run differs significantly among authors, we classify these leading authors into four different groups according to their choice of approach:

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