How is moral suasion related to the two theories of interest rate determination? How are open market operations related to the two theories of interest rate determination?
The correct answer and explanation is:
Correct Answer:
Moral suasion and open market operations influence interest rates through their effects on money supply and demand. These tools relate to the loanable funds theory and the liquidity preference theory of interest rate determination in different ways.
Explanation (300 words):
The loanable funds theory states that the interest rate is determined by the supply and demand for loanable funds. Supply comes from savings, while demand arises from investments and borrowing. If the central bank uses moral suasion, it tries to persuade financial institutions to restrict or expand lending voluntarily. For example, if it encourages banks to reduce lending, the supply of loanable funds falls, leading to higher interest rates. Conversely, if banks are urged to increase lending, the supply increases, and interest rates fall. Although there is no direct action, the influence shifts the supply side of the loanable funds market.
On the other hand, open market operations (OMOs), which involve buying or selling government securities, directly affect the amount of money banks have to lend. When the central bank buys securities, it injects money into the banking system, increasing the supply of loanable funds. This shifts the supply curve to the right and lowers the interest rate. When the central bank sells securities, it withdraws money from the system, decreasing supply and raising interest rates.
The liquidity preference theory, developed by Keynes, states that the interest rate is determined by the demand and supply for money. Demand for money depends on transactions, precautionary, and speculative motives. Supply is controlled by the central bank. In this theory, moral suasion affects interest rates by influencing expectations and preferences, possibly shifting the demand curve for money. Open market operations directly change the money supply. An increase in supply (through OMOs) lowers interest rates, while a decrease raises them.
Thus, both moral suasion and OMOs influence the equilibrium interest rate by shifting the supply or demand in the respective frameworks of loanable funds and liquidity preference theories.