What Is the Market Rate of Interest
The market rate of interest is a factor which can affect the supply, demand, risk, and expected rate of return. It is also a factor which has an impact on the business world as well as on individual people.
Short-term rates
Short-term interest rates refer to the market rate of interest for short-term borrowing between financial institutions. They are used to calculate the prime rate, which is the base rate used by banks to price short-term business loans.
The Fed has raised short-term rates from 0.25% to 2.5% since March. The Fed expects the rates to be around a percentage point higher in the next year.
In the immediate postwar period, short-term rates were often higher than long-term rates. This was due to factors such as war finance, easy money policies, the great depression, and other special factors.
By the late 1930s, short-term rates were close to long-term rates. However, they started to fluctuate more in the business cycle. Prior to the Federal Reserve System's operation, short-term rates were generally equal to long-term rates.
In the late 1950s, the spread between the yields on short-term government bonds and corporate bonds widened to one percentage point. Despite this widening, commercial paper rates remained well below the 1957 level.
Long-term bond yields approached their 1957 highs by the mid-1960s, but they did not stay there. Rates reached peak levels in 2006-2007. As a result of this rise in interest rates, bond prices fell. During this period, the Fed was on the leading edge of the hiking cycle.
Influence of supply, demand, risk, and expected rate of return
The law of supply and demand is the concept that the amount of money demanded and the price paid for something will change in response to changes in the level of supply and demand. This can be seen by the relationship between interest rate and demand. A higher interest rate will decrease the quantity of money demanded while a lower interest rate will increase the demand for money.
As we see from the chart, the speculative demand for money is a function of expectations about future price levels, whereas the interest rate is a function of the rate of return earned by depositing money. Similarly, the price of a bond is a function of the expected interest rate.
For example, a low interest rate is the omen of a high price for a bond. Similarly, a higher price will increase the quantity demanded, but a fall in price will decrease the demand for a bond.
Another important effect of the law of supply and demand is the money supply. During the technology boom in the late 1990s, more businesses were confident in the return on their investments, and so were able to raise the supply of financial capital. In the Great Recession, the supply curve for the financial market was shifted to the left.
