What Should We Teach Our Students about Interest Rates Determination

By Khandker, A. Wahhab; Khandker, Amena | Journal of Economics and Economic Education Research, January 1, 2013 | Go to article overview

What Should We Teach Our Students about Interest Rates Determination


Khandker, A. Wahhab, Khandker, Amena, Journal of Economics and Economic Education Research


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:

1 . …

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

What Should We Teach Our Students about Interest Rates Determination
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.