Interest rates and the money market

Economic growth is a plus, but, like all good things, it's best not to have too much at once. If the economy grows too rapidly, the result can be inflation. Steady growth is best, and governments use fiscal and monetary policy tools to achieve this. For example, they set interest rates in order to control borrowing and investment. However, the government can't just state, 'today's interest rate is four per cent' and expect all the other banks to follow. As usual, things are a bit more complicated! The interest rate is not really set by the government at all, but by the levels of demand and supply of money in the money market. Imagine that money is like any other commodity, and the price of money is the interest rate. Banks can charge any interest rate that customers are willing to pay. If there is a limited amount of money available, the suppliers (the banks) will charge a higher price (the interest rate) as demand for money increases. Demand comes from the public who want to spend money to buy things and from businesses who want to invest money in order to grow. Just like other commodities, demand for money will fall as the price (interest rate) rises.

The interest rate will be set by the market. It will be where the demand and supply curves meet – the equilibrium point.

Also, just like other markets, there can be shifts in the demand and supply curves. When shifts happen, the equilibrium point (the interest rate that is set) changes. This new interest rate may be above or below the government's target. What can they do about it? One thing they can do is to influence the supply of money in the market.

What exactly is the money supply and how can the government influence it? Obviously, the money supply includes all the notes and coins in purses, pockets and cash tills. Some of this money will be money that has been borrowed from banks, so loans form part of the money supply too. The supply also includes money that people and companies have in bank accounts, and the money that banks have in their reserve accounts in the central government bank.

Remember that banks lend most of the money that customers deposit. When customers want to make withdrawals, the bank takes cash from its reserve account with the central government bank. If the commercial bank has a shortage of cash in its reserve account, it is obliged to borrow from the central bank. When a commercial bank borrows from the central bank, it must borrow at the government's rate of interest. This is how the government can influence the interest rate equilibrium point of the market.

However, the government needs to ensure that at the end of each day the commercial banks have a shortage of cash. And, of course, they have ways of doing this!

(from Raitskaya L., Cochrane S.Macmillan Guide to Economics, Издательство: McMillan, 2005)

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International trade

There are plenty of incentives for a country to have an open economy. Exports increase the size of the market for producers. Imports stimulate competition in local markets and provide a wider choice for consumers. These are good reasons for international trade. However, another important reason for trading is to exploit advantages. Economists talk about two types of advantage that an economy can have over others: absolute advantage and comparative advantage.

An economy has absolute advantage when it can produce goods at a lower cost than other economies can, or they have resources that others don't have. For example, warm Mediterranean countries have an absolute advantage in the production of olive oil. Many countries in Asia have an absolute advantage in manufacturing electronic goods. Clearly, it makes sense for countries with absolute advantages to trade with each other.

The second kind of advantage is comparative advantage. This happens when an economy can produce something at a lower opportunity cost than other economies can. Remember that the opportunity cost of something is what you have to give up in order to have it. For example, imagine that country A makes two things with its resources: clothes and furniture. If it wants to increase production of clothes, it must decrease its production of furniture. This loss is the opportunity cost. Now imagine that country В also makes clothes and furniture, but it makes less of both than country A. In other words, country A has an absolute advantage over country В in clothes and furniture. However, country В can increase its production of clothes with only a small opportunity cost in furniture. This means that country В has a comparative advantage over country A in the production of clothes.

But why would country A want to trade with country B? What benefit would they gain? In fact, both countries can benefit by specialising. If country A produces only furniture, and country В produces only clothes, both countries will be making best use of their available resources. By trading in this way, production of both products increases. In turn, this increases the economic welfare of both countries.

Despite all the advantages of having an open economy, countries sometimes restrict trade with other countries. For example, governments may charge tariffs on imports. These are taxes which make imports more expensive than locally produced products. Governments may also restrict the amount of imports entering the country. This kind of restriction is called an import quota. Since international trade has so many benefits, why would countries want to restrict trade in this way? There must be some very good reasons!

(from Raitskaya L., Cochrane S.Macmillan Guide to Economics, Издательство: McMillan, 2005)

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