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How are they determined?

Well, this is going to be controversial! Our view is that the Fed does not control interest rates. Keynesians and Fed aficionados are not going to appreciate this view, but we feel the need to express it. We are trying to get beyond following interest rates as an indicator of monetary policy.

Can you say endogenous (en dah jen us)?

Interest rates are endogenous. This means that they are determined by processes within the economic system. Interest rates are not controlled by outside forces, including the Fed.

Does the Fed influence rates?

The answer is yes.

How do Keynesians think it works?

For Keynesians, the influence is primarily through the Keynesian effect or what is also known as the liquidity effect. Here, an increase in money or an increase in the rate of the growth of money causes interest rates to fall. They also might believe that interest rates in general are controlled because the Fed does control its discount rate. In addition, the Federal Funds Rate sounds as if it is controlled by the Fed.

How do monetarists think it works?

Monetarists think in terms of an increase in money growth leading to an increase in the rate of inflation and thus expectations of future inflation. In turn, this affects interest rates through the Fisher effect. The Fisher effect is the equation in which the nominal interest rate is the sum of the real rate of interest and the expected rate of inflation.

Is there a middle ground between Keynesians and monetarists?

Possibly. It might be that the Keynesian effect is more rapid than the Fisher effect. However, it is unlikely that the order of magnitude of the Keynesian effect is as large as the Fisher effect. In addition, it should be emphasized that these two views run in opposite directions. Keynesians think that increasing money results in lower rates and monetarists think that it results in higher rates.

Do low rates equate to an expansionary monetary policy?

Not necessarily. For example, currently (7/10) interest rates are low. Does that mean that monetary policy is expansionary? No. It is more likely that interest rates are low because the expected rate of inflation is low and the real rate of interest (think the real growth rate of GDP) is low. In common parlance, interest rates are low because the economy is in the dumper.

So what determines the level of interest rates?

Interest rates are determined in credit markets. Borrowers are the demand side and lenders are the supply side. The prices of credit in these markets are interest rates. The Fed can enter these markets, especially the markets for government securities, and directly move interest rates at the margin. Why only at the margin? The answer is probably that the demand and supply curves are quite flat, in the jargon of economics this would be that demand and supply are interest rate elastic. By entering the credit market and exercising open market operations, the Fed is affecting the money supply and ultimately the rate of inflation. This potentially moves interest rates more than marginally and in the opposite direction.