The document discusses the key factors that influence changes in interest rates. It explains that interest rates are determined by the supply and demand of funds in the market. A rise in interest rates occurs when demand for borrowing increases or supply of savings decreases, while a fall happens in the reverse situation. It then analyzes how savings behaviors, central bank actions, and economic conditions of countries can impact supply and demand in the market. Specifically, wealthy nations save more so have lower rates, while central banks use tools like bond purchases and lending rates to influence market rates.

1. The Mystery Behind
Changing Interest Rates
MARCH 17, 2018

2. Objective of the Session
To provide insights into some of the forces
that cause interest rates to move up and down
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3. Why should We Worry about Interest
Rates?
Three Key Economic Outcomes which has a Direct Impact on Our Daily Lives
Unemployment
G D P Inflation
Interest Rates
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4. 4

5. What is Market Interest Rates?
Interest rate determined by the market forces.
Market forces: supply of funds through savings in the market and the demand for that funds to
borrow.
High demand and / or low supply means that lenders can charge higher interest rates without
losing business to competitors with lower rates.
Low demand and / or high supply means that lenders must offer lower interest rates in order to
entice borrowers.
Sadly, this interest rate is not directly observable in the market, unlike the yield on a 90 DTB, for
instance.
But, its movements can be observed through some benchmarks like call money rates, T-bill rates
of various maturities and actively traded G-Secs.
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6. Demand for and Supply of Funds &
Equilibrium Interest Rates
InterestRates
Quantity of Savings and Borrowings
Demand to Borrow
Supply of Savings
Savings, borrowings
and interest rates at
equilibrium
r1
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7. Fall in Equilibrium Interest Rates.
InterestRates
Quantity of Savings and Borrowings
Demand to Borrow
Supply of Savings
Savings, borrowings
and interest rates at
equilibrium
S1
S2
r1
r2
D1
D2
r3
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8. Rise in Equilibrium Interest Rates.
InterestRates
Quantity of Savings and Borrowings
Demand to Borrow
Supply of Savings
Savings, borrowings
and interest rates at
equilibrium
S1
S2
r1
r2
D1
D2
r3
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9. To Summarize
A rise in interest rates is caused by one or both of the following:
◦ An increase in demand
◦ A decrease in supply
A fall interest rate is caused by one or both of the following:
◦ A decrease in demand
◦ An increase in supply
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10. Theory in Real Life
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11. Impact of Changing Interest Rates
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12. Therefore, we must know why the interest rates move up & down.
In the next few slides, we will try and figure out some of the
fundamental drivers of interest rates.
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13. Fundamental Forces Influencing Interest
Rates
Savings flow in the economy.
Central Bank actions.
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14. Savings Flow
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15. Present Bias
“Satisfaction of a want in the nearer future is, other things
being equal, preferred to that in the farther distant future.
Present goods are more valuable than future goods.”
-Ludwig Von Mises
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16. Poor will Save Less, Borrow More
An individual who has just enough resources to keep him alive is
unlikely to save or lend his paltry means.
The cost of saving, or lending, to him is likely to be very high — it
might even cost him his life.
Hence, the poor can be expected to save less, even borrow more.
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17. Wealthy will Save More, Borrow Less
Wealthy people will have enough resources left over, even after
meeting all their present biased consumption needs.
Once his wealth starts to expand the cost of saving, or lending, starts
to diminish.
Hence wealthy people can be expected to save or lend more, borrow
less.
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18. Equilibrium Interest Rates: Rich Country
InterestRates
Quantity of Savings and Borrowings
Demand to Borrow
Supply of Savings
Savings, borrowings
and interest rates at
equilibrium
+
-
0
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19. Equilibrium Interest Rates: Poor Country
InterestRates
Quantity of Savings and Borrowings
Demand to Borrow
Supply of Savings
Savings, borrowings
and interest rates at
equilibrium
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20. Is it True?
Countries Central Bank Key Rate
Switzerland -0.75
Denmark -0.65
Sweden -0.50
Japan -0.10
US 0.50
D R Congo 14
Gambia 20
Ghana 21
Mozambique 21.75
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21. 21

22. The Vicious Cycle of High Interest Rates
High
Interest
Rates
Low
Economic
Growth
Countries
Staying
Poor
High
Demand for
Borrowing,
Low Savings
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23. Import Savings from Rich Countries aka
FII and FDI
InterestRates
Quantity of Savings and Borrowings
Demand to Borrow
Supply of Savings
Savings, borrowings
and interest rates at
equilibrium
Supply of Savings
New equilibrium at
lower interest rate
Interest Rate in a Poor Country
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24. Call Money Rates in India 1990 - Present
0
5
10
15
20
25
PercentageCallrates
Year
Annual Average Call Rates
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25. Central Bank Actions
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26. Central Bank Balance Sheet
The conduct of monetary policy by the central bank involves actions
that affect its balance sheet. This is a simplified version of its
balance sheet, which we will use to illustrate the effects of central
bank actions.
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27. Central Bank Balance Sheet: Liabilities
The monetary liabilities of the CB include:
◦ Currency in circulation: the physical currency in the hands of the public, which
is accepted as a medium of exchange worldwide.
◦ Reserves: All banks maintain deposits with the CB, known as reserves. The
cash reserve ratio, set by the CB, determines the required reserves that a bank
must maintain with the CB.
◦ In India, the current CRR rate is 4%.
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28. Central Bank Balance Sheet: Assets
The monetary assets of the CB include:
◦ Government Securities: These are the Govt. Treasury bills and bonds that the
CB has purchased in the open market. As we will show, purchasing Treasury
securities increases the money supply.
◦ Discount Loans (DL): These are loans made to member banks at the current
discount rate. Again, an increase in discount loans will also increase the
money supply.
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29. Open Market Operations
In the next two slides, we will examine the impact of open market
operation on the CB’s balance sheet and on the money supply. As
suggested in the last slide, we will show the following:
◦ Purchase of bonds increases the money supply
◦ Making discount loans increases the money supply
Naturally, the CB can decrease the money supply by reversing these
transactions.
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30. Public
Assets Liabilities
Securities
–$100
Deposits
+$100
The CB
Assets Liabilities
Securities Reserves
+$100 +$100
Banking System
Assets Liabilities
Reserves Deposits
+$100 +$100
Result R  $100, MB  $100
The CB Balance Sheet
Open Market Purchase from Public
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31. The CB Balance Sheet
Discount Lending
The CB
Assets Liabilities
Discount loans Reserves
+$100 +$100
Banking System
Assets Liabilities
Reserves Discount loans
+$100 +$100
Result R  $100, MB  $100
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32. Supply and Demand in the Market for
Reserves
We now have some understanding of the effect of open market
operations and discount lending on the CB’s balance sheet and
available reserves.
Next, we will examine how this change in reserves affects the
Overnight lending and borrowing rates in the money market (Call
money rates), the rate banks charge each other for overnight loans.
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33. Supply and Demand in the Market for
Reserves
1. Demand curve slopes down
because as iff ,
banks keep more reserves
2. Supply curve is vertical
because quantity of reserves
available with the banking
system at a time is fixed.
3. Equilibrium iff where Rd = Rs
Rs=supply curve, Rd=demand curve
NBR=non-borrowed reserves
iff=interest on federal funds (call rate)
id is the equivalent of repo rate
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34. Supply and Demand in the Market for Reserves:
RBI Purchases G-Secs through OMO
1. Open market
purchase, Rs shifts
to right and iff 
2. id , DL , Rs shifts
to right and iff 
Similarly, if CRR is reduced, NBR1 will
move to NBR2. Then also the call money
rates will fall from iff1 to iff2
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35. Federal Reserve Assets and Federal
Funds Rate
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36. To Conclude...
Three fundamental drivers of interest can be:
◦ State of the economy: whether poor or rich economy.
◦ Ability to attract foreign savings (Foreign portfolio and foreign institutional
investments).
◦ Expansion or contraction of central bank balance sheet.
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37. Thank you......
Open for Questions & Discussion
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38. Tailpiece
Neither a borrower nor a lender be;
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.
This above all: to thine ownself be true,
And it must follow, as the night the day,
Thou canst not then be false to any man.
Farewell: my blessing season this in thee!
-Lord Polonius in William Shakespeare's Hamlet, Act I, Scene III
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