THE MINISTRY OF HIGHER AND SECONDARY SPECIALIZED EDUCATION OF THE REPUBLIC OF UZBEKISTAN TASHKENT INSTITUTE OF FINANCE PRESENTATION INTEREST RATE AND INTEREST RATE POLICY Done by Khikmatullaeva Saida Group MM22i Tashkent 2019

OUTLINE 1.Interest rate and its essence 2.Components of interest rate 3.Structure of interest rate and its level 4.Reasons for interest rate changes 5.Interest rate policy 6.Relationships between interest rate and unemployment

INTEREST RATE AND ITS ESSENCE Interest-the cost of borrowing interest rate-the rate expressed as a percentage of the total sum borrowed for a stated period of time. Basically determined by demand and supply of funds.

INTEREST RATE The interest rate is the amount of interest paid per unit of time as a fraction of the balance outstanding. Fisher relation REAL interest rate = NOMINAL interest rate minus inflation r = i -

WHAT DETERMINES INTEREST RATES? S D1D1 D AA1A1 r1r1 r I, S r D1D1 D S1S1 S S1S1 S E E1E1 D r

THE FIVE COMPONENTS OF INTEREST RATES 1. Real Risk-Free Rate 2. Expected Inflation 3. Default-Risk Premium 4. Liquidity Premium 5. Maturity Premium

STRUCTURE AND ITS LEVEL DEPENDS ON: the behavior of the yield curve composition of the maturity structure sensitivity of the change in the interest rate, and, default risk included in matching the level of interest rate and its relationshipwith the yield curve.

REAL VS NOMINAL INTEREST RATES The nominal interest rate is the amount, in percentage terms, of interest payable.nominal interest rate The real interest rate, which measures the purchasing power of interest receipts, is calculated by adjusting the nominal rate charged to take inflation into account. The real interest rate, which measures the purchasing power of interest receipts, is calculated by adjusting the inflation Nominal interest rate =Real interest rate+inflation.

SPREAD RATE AND BASE RATE The spread of interest rates=lending rate - deposit rate. This covers operating costs for banks providing loans and deposits. A negative spread is where a deposit rate is higher than the lending rate The base rate is lowest rate at which a bank will charge interest, also known as the repo rate. The rate is set by the monetary policy with a view to controlling inflation over the medium-term. Banks usually charge interest at a stipulated figure 'above base rate'. If the base rate rises, then usually the rate of interest charged on the loan will rise to preserve the differential. If it falls, so will the rate on the loan.

REASONS FOR INTEREST RATE CHANGES Political short-term gain Deferred consumption Inflationary expectations Alternative investments Risks of investment Liquidity preference Taxes Banks Economy

Primary target PRICE STABILITY Intermediate targets Money supply Interest rates Exchange rate Instruments Direct: Interest regulations Credit controls Market based: Discount rate Reserve ratio Open market operations MONETARY POLICY

MONETARY POLICY AND AGGREGATE DEMAND Substitution effect (-) r (-) S (+) C Cash flow (income) effect (-) r (+) cash flow of borrowers (-) r (-) cash flow of lenders Wealth effect (-) r (+) in asset values (-) r (+) C (+) I

MONETARY POLICY AND AGGREGATE DEMAND (Cont.) CB credibility effect (-) r (+) domestic confidence in CB (-) r (-) domestic price and wage increases Exchange rate effect (-) r depreciation of real exchange rate (+) X, (-) M

Expansionary monetary policy Higher money base Lower interest rate Growing private sector credit More spending Consumer price increase Asset price inflation More output in short run Inflation Capacity constraint/ tight labour market

RELATIONSHIP BETWEEN INFLATION AND INTEREST RATES Interest rates, more people are able to borrow more money. The result is that consumers have more money to spend, causing the economy to grow and inflation to increase. The opposite holds true for rising interest rates. As interest rates are increased, consumers tend to have less money to spend. With less spending, the economy slows and inflationdecreases. Like in demand-pull theory, Lower interest rates put more borrowing power in the hands of consumers. And when consumers spend more, the economy grows, naturally creating inflation. If the central bank decides that the economy is growing too fast (which is a bad sign in the long term), They will try to minimize the effect of it by increasing the interest rates and vice versa, this rising interest rates in turn will encourage people to save more and borrow less thus reducing the amount of money in circulation in the market. Lesser money in the market makes it difficult to buy the goods and services thus slowing down the rise in price. In short, stable economy is a healthy economy with right wages and less unemployment.

MONETARY POLICY CAN SOMETIMES FAIL Problem 1: Keynes liquidity trap where nominal interest rates fall to such a low level that no further cuts are expected (LM curve flat) Problem 2: IS curve very steep, so outward shift of LM affects interest rate but not output Problem 3: If prices are falling, the real interest interest rate rises, investment is deterred. Since nominal interest rates cannot fall below zero, central bank powerless. The Japan case.