International Finance Theory and Policy
by Steven M. Suranovic

Finance 40-2

Some Preliminaries

There are several sources of confusion that can affect complete understanding of this basic model.

The first source of confusion concerns the use of the term "money." In casual conversation money is sometimes used more narrowly and sometimes more broadly than the formal definition. For example, someone might exclaim, " I want to be a doctor so I will make a lot of money." In this case the person is really referring to income, not money, per se. Since income is typically paid using money, the everyday substitution of the term money for income does make sense, but it can lead to confusion interpreting the forthcoming model. In general people use the term money whenever they want to refer to a country's coins and currency and anything these items are used for in payment. However, our formal definition of money also includes items that are not coin and currency. Checking account deposits are an example of a type of money included in the formal definition, but not more casually thought of as money. Thus, pay attention to the definition and description below and be sure to recognize that one's common conception of money may or may not overlap precisely with the formal definition.

A second source of confusion involves our usage of the term "interest rate." The model that will be developed will derive an equilibrium interest rate for the economy. However, everyone knows that there are many interest rates in the economy and each of these rates are different. There are different rates for your checking and savings account, different rates on a car loan and mortgage, different rates on credit cards and government bonds. Thus, it is typical to wonder, what interest rate are we talking about when we describe "the" equilibrium interest rate.

It is important to note that financial institutions make money (here I really should say 'make a profit') by lending to one group at a higher rate than it borrows. In other words, financial institutions accept deposits from one group of people (savers) and lend it to another group of people (borrowers.) If they charge a higher interest rate on their loans than they do on deposits, the bank will make a profit.

This implies that, in general, interest rates on deposits to financial institutions are lower than interest rates on their loans. When we talk about the equilibrium interest rate in the forthcoming model, it will mostly apply to the interest rates on deposits rather than loans. However, here too we have a small problem in interpretation since different deposits have different interest rates. Thus, which interest rate are we really talking about?

The best way to interpret the equilibrium interest rate in the model is as a kind of average interest rate on deposits. At the end of this chapter we will discuss economic changes that lead to an increase or decrease in the equilibrium interest rate. We should take these changes to mean several things. First, that average interest rates on deposits will rise. Now, some of these rates might rise and a few might fall, but there will be pressure for the average to increase. Second, since banks may be expected to maintain their rate of profit if possible, when average deposit interest rates do increase, so will average interest rates on loans too. Again some loan rates may rise and some fall, but the market pressure will tend to push them upward.

The implication is that when the equilibrium interest rate changes we should expect most interest rates to move in the same direction. Thus the equilibrium interest rate really is referring to an average interest rate across the entire economy, for deposits and for loans.

International Finance Theory and Policy - Chapter 40-2: Last Updated on 1/11/05