THE DETERMINANTS OF SHORT-TERM INTEREST …

1 THE DETERMINANTS OF SHORT-TERM INTEREST rates By GAVIN LEE OSTER submitted in fulfillment of the requirement for the degree of MASTER OF COMMERCE in the subject ECONOMICS at the UNIVERSITY OF SOUTH AFRICA SUPERVISOR: PROF. PJ MOHR NOVEMBER 2003 Acknowledgments I wish to acknowledge Professor P J Mohr s patience and unwavering support in assisting me to complete this dissertation. His extensive knowledge of economics made this an enlightening project. This dissertation is dedicated to my father Selwyn, and my mother Ros who never stopped believing in me and whose emotional and financial support made this all possible.

2 Johannesburg November 2003 SUMMARY SHORT-TERM INTEREST rates are key economic variables, yet few people understand how these rates are determined. This confusion extends to the theoretical level. In neoclassical INTEREST -rate theory for instance, the INTEREST rate is determined by the supply of and demand for loanable funds. Contrary to this view, the Post Keynesian approach suggests that the INTEREST rate is determined by central banks as a key policy variable in pursuit of its monetary policy objective/s. This dissertation examines how the current and previous Governors of the South African Reserve Bank deliberately used SHORT-TERM INTEREST rates to exert an influence on the general level of SHORT-TERM INTEREST rates . In doing so, they implicitly adopted the Post Keynesian approach.

3 This view is shared by most central bankers today, giving credence to the widespread recognition that SHORT-TERM INTEREST rates are determined as a policy variable and not by impersonal market forces. CONTENTS Page CHAPTER ONE CHAPTER TWO: INTEREST RATE THEORY DEFINITION AND TYPES OF INTEREST Defining the rate of SHORT-TERM INTEREST Long-term INTEREST The term structure of INTEREST INTEREST RATE THE LOANABLE FUNDS THE LIQUIDITY PREFERENCE THEORY OF THE RATE OF CHAPTER THREE: POST KEYNESIAN INTEREST RATE THEORY POST MAIN TENETS OF POST KEYNESIAN MONETARY INTEREST rates IN POST KEYNESIAN The exogeneity of the INTEREST A mark- up theory of INTEREST rate CHAPTER FOUR: MONETARY POLICY REGIMES 43 THE DEFINITION AND OBJECTIVES OF MONETARY INTEREST RATE POLICY UNDER DIFFERENT MONETARY Direct INTEREST rate controls.

4 Implications for INTEREST rate Fixed exchange Exchange rate Monetary targeting as a framework for monetary Inflation Monetary policy without an explicit nominal CHAPTER FIVE: MOVEMENTS OF PRIME OVERDRAFT INTEREST rates , 1981 - 2002 THE DE KOCK ERA (1981- 1989)..62 Economic Movements in prime INTEREST rates during the De Kock Concluding remarks on the De Kock THE STALS ERA (1989 1999)..88 Economic Movements in prime INTEREST rates during the Stals Concluding remarks on the Stals THE MBOWENI ERA (1999-2002)..110 Economic Movements in prime overdraft INTEREST rates during the Mboweni Concluding remarks on the Mboweni CHAPTER SIX LIST OF FIGURES Page FIGURE DIFFERENT POSSIBLE SHAPES OF THE YIELD CURVE 6 FIGURE THE CLASSICAL THEORY OF THE RATE OF INTEREST 10 FIGURE DETERMINATION OF THE EQUILIBRIUM INTEREST RATE IN THE KEYNESIAN SYSTEM 17 FIGURE THE MONETARIST VIEW: ENDOGENOUS INTEREST RATE 30 FIGURE THE POST KEYNESIAN VIEW.

5 EXOGENOUS INTEREST RATE 31 LIST OF TABLES Page TABLE MOVEMENT OF KEY VARIABLES DURING THE DE KOCK ERA 69 TABLE MOVEMENT OF KEY VARIABLES DURING THE STALS ERA 96 TABLE MOVEMENT OF KEY VARIABLES DURING THE MBOWENI ERA 116 1 CHAPTER 1 INTRODUCTION How are SHORT-TERM INTEREST rates determined?

6 In neoclassical INTEREST -rate theory the INTEREST rate is determined by the supply of and demand for loanable funds. Contrary to this view, the Post Keynesian approach suggests that the INTEREST rate is determined by central banks as a key policy variable in pursuit of its monetary policy objective/s. This dissertation examines how the current and previous Governors of the South African Reserve Bank deliberately used SHORT-TERM INTEREST rates to exert an influence on the general level of SHORT-TERM INTEREST rates . In doing so, they implicitly adopted the Post Keynesian approach. This view is shared by most central bankers today, giving credence to the widespread recognition that SHORT-TERM INTEREST rates are determined as a policy variable and not by impersonal market forces. The dissertation is set out as follows: In Chapter 2, alternative theories of INTEREST rate determination are critically discussed.

7 Questionable assumptions in both the loanable funds and the liquidity preference theory suggest that both theories are found wanting in their attempt to explain the DETERMINANTS of SHORT-TERM INTEREST rates . These deficiencies are addressed in Chapter 3 with the introduction of the Post Keynesian approach to INTEREST rate determination. According to this theory, the rate charged by central banks to the commercial banking sector for accommodation is an instrument of monetary policy, and not a market determined price. Central banks set SHORT-TERM INTEREST rates and they do so within in the context of a particular monetary policy framework. These frameworks are discussed in Chapter 4. In Chapter 5 the movement in the prime overdraft INTEREST rate in South Africa during the period 1981-2002 is discussed. The intention of this analysis is to assess wether SHORT-TERM INTEREST rates are set by market forces, or by the Reserve Bank as a policy variable.

8 Chapter 6 concludes with the view that, from a South African perspective, SHORT-TERM INTEREST rates are determined in a manner that is consistent with Post Keynesian INTEREST rate theory. 2 CHAPTER 2 INTEREST RATE THEORY The theory of INTEREST has for a long time been a weak spot in the science of economics, and the explanation and determination of the INTEREST rate still gives rise to more disagreement among economists than any other branch of general economic theory (Haberler 1958: 195). INTRODUCTION In order to understand the DETERMINANTS of SHORT-TERM INTEREST rates , it is important to first define the rate of INTEREST . Once this has been done, the spectrum of INTEREST rates has to be divided into long-term and SHORT-TERM categories. Once we have identified the relevant category for each INTEREST rate, we turn to economic theory in order to understand how INTEREST rates are determined.

9 As the focus in this dissertation is on SHORT-TERM INTEREST rates , long-term INTEREST rates will be mentioned only briefly. As far as the DETERMINANTS of SHORT-TERM INTEREST rates are concerned, the basic question in this dissertation is whether they are determined by market forces or as a policy variable. If market forces determine SHORT-TERM INTEREST rates , then it is necessary to explore the dynamics of the supply of and demand for money in the financial markets. In such a case, SHORT-TERM INTEREST rates are determined endogenously as a by-product of market forces. On the other hand, if we accept the notion that SHORT-TERM INTEREST rates are used an instrument of monetary policy and are manipulated deliberately by central banks in pursuance of their specific monetary policy objectives, then SHORT-TERM INTEREST rates are determined exogenously by the monetary authorities as a policy variable and their goals and actions have to be examined.

10 3 DEFINITION AND TYPES OF INTEREST RATE Defining the rate of INTEREST INTEREST can be defined as the price a borrower has to pay to enjoy the use of cash which he or she does not own, and the return a lender enjoys for deferring consumption or parting with liquidity (Bannock et al 1998: 346). The concept of INTEREST embraces theories of time preference, marginal productivity, liquidity preference and loanable funds. The apparently diverse views of INTEREST can be grouped into two broad classes: real and monetary. Real theories of INTEREST are long-run theories in which INTEREST is the return for real abstinence and the yield on real capital. Monetary theories, on the other hand, are short -run theories in which the monetary rate of INTEREST is the cost of borrowing money and selling securities, and the yield on lending money and purchasing securities.