[quint101]

Hello,

Need some clarification about how increased government borrowing also increase interest rates.

I thought interest rates were independant (set by MPC)? Or is this referring to yield rates?

Can someone please explain this, and if possible the whole "crowding out" process? I do not understand how interest rates, and bond prices are affects via increased government borrowing.

Many thanks.

[Classical Liberal]

(Original post by quint101)
Hello,

Need some clarification about how increased government borrowing also increase interest rates.

I thought interest rates were independant (set by MPC)? Or is this referring to yield rates?

Can someone please explain this, and if possible the whole "crowding out" process? I do not understand how interest rates, and bond prices are affects via increased government borrowing.

Many thanks.

If the government borrows money it has to issue IOUs (bonds). If it borrows more money it has to issue more IOUs. This increases the supply of IOUs. This decreases the price people are willing to pay for said IOUs as there is more supply. Thus the interest rate (the price) people pay on said IOUs rises.

The crowding out effect occurs because when the government issues bonds (IOUs) and investors put their money in those bonds, those investors can no long give that money to the private sector for investment.

This means there is less money to be invested into the private sector. This means that the private sector has to raise interest rates to attract investors because the supply of potential investment has fallen.

[MagicNMedicine]

(Original post by quint101)
Hello,

Need some clarification about how increased government borrowing also increase interest rates.

I thought interest rates were independant (set by MPC)? Or is this referring to yield rates?

Can someone please explain this, and if possible the whole "crowding out" process? I do not understand how interest rates, and bond prices are affects via increased government borrowing.

Many thanks.

Simplest way to start thinking about this is in terms of the supply and demand for loans. There will be a supply of loanable funds, which is made up of people wanting to save, so they have funds put aside now that they don't want to use yet, to lend to others, through a bank etc.

The interest rate is the price of loans, that price is set by supply and demand for loans. If you hold the supply constant and the government increases borrowing then that is an increase in the demand for loans hence the price will go up.

As for bonds there are different forms of bond, government bonds and bonds issued by firms in the private sector. There will be a spread of interest rates here which will be determined by things like how risky they are seen, the more risky the bond the higher the interest rate. Bonds are basically forms of loans, if you 'buy a bond' from another party (eg government) then you are lending them money because you pay them money now in exchange for the promise ('bond') to repay with interest at a later date. So when government increases borrowing what it really means is government issues more bonds.

The price of a bond is inversely proportional to the interest rate (yield). If a bond that promises to pay £100 in a year's time sells for £90 now then that's a yield of 11.11%, because you are paying £90 now for the bond and you get an 11.11% increase when you get £100 in a year by redeeming the bond. But if that same bond sold for £95 then the yield is only 5.26%, because £95 invested at 5.26% for a year is £100 and that's what you get when you redeem it next year. Higher price on a bond means lower interest rate and vice versa.

When the government is borrowing more it will be issuing more bonds which means the supply of government bonds increases, so if demand for government bonds stays constant then the price of government bonds will fall hence the yield on government bonds rises.

If the yields on government bonds are rising then that will tend to drive up the yields of bonds from other firms because if there were large discrepancies investors would just switch out of the lower yield ones to the higher yields.

[quint101]

(Original post by MagicNMedicine)
Simplest way to start thinking about this is in terms of the supply and demand for loans. There will be a supply of loanable funds, which is made up of people wanting to save, so they have funds put aside now that they don't want to use yet, to lend to others, through a bank etc.

The interest rate is the price of loans, that price is set by supply and demand for loans. If you hold the supply constant and the government increases borrowing then that is an increase in the demand for loans hence the price will go up.

As for bonds there are different forms of bond, government bonds and bonds issued by firms in the private sector. There will be a spread of interest rates here which will be determined by things like how risky they are seen, the more risky the bond the higher the interest rate. Bonds are basically forms of loans, if you 'buy a bond' from another party (eg government) then you are lending them money because you pay them money now in exchange for the promise ('bond') to repay with interest at a later date. So when government increases borrowing what it really means is government issues more bonds.

The price of a bond is inversely proportional to the interest rate (yield). If a bond that promises to pay £100 in a year's time sells for £90 now then that's a yield of 11.11%, because you are paying £90 now for the bond and you get an 11.11% increase when you get £100 in a year by redeeming the bond. But if that same bond sold for £95 then the yield is only 5.26%, because £95 invested at 5.26% for a year is £100 and that's what you get when you redeem it next year. Higher price on a bond means lower interest rate and vice versa.

When the government is borrowing more it will be issuing more bonds which means the supply of government bonds increases, so if demand for government bonds stays constant then the price of government bonds will fall hence the yield on government bonds rises.

If the yields on government bonds are rising then that will tend to drive up the yields of bonds from other firms because if there were large discrepancies investors would just switch out of the lower yield ones to the higher yields.

Thanks. So the rising interest rate (via higher demand, fixed supply of loans), and higher bond yields are separate, but are both caused by government lending?
Also, what role does the MPC's interest rate have on all of this?

[MagicNMedicine]

(Original post by quint101)
Thanks. So the rising interest rate (via higher demand, fixed supply of loans), and higher bond yields are separate, but are both caused by government lending?
Also, what role does the MPC's interest rate have on all of this?

Yes the rising interest rate is basically just the fall in the price of bonds (see my explanation above about it being inversely proportional). The more government is borrowing, the more bonds it is issuing (as that is how it borrows its money, by selling bonds for cash now that it redeems later, the difference between the redemption price and what it gets now from the buyer will determine the rate of interest when you take into account the time between now and redemption).

The MPC influences the interest rate through controlling the money supply. Money is useful because it can be used for transactions but it does not bear interest if you hold it, whereas holding assets like bonds bear interest but you can't use them for transactions, you have to sell them and convert them into cash first. So there will be a downward sloping demand for money, when bonds bear high interest the demand for money will be low but when bonds bear low interest the demand for money will be high. This is because when interest rates are high people will store a bigger proportion of their wealth in bonds (to get the interest) and forego spending now, in practice if you hold money in some form of savings account the bank buys bonds on your behalf so this is effectively like holding bonds. But this is less convenient than holding money as you can't access savings to spend on transactions straight away, you have to sell the bonds first (hence savings accounts at banks being not usually 'immediate access' to the depositor). So when interest rates are low you would just say there's no point tying my wealth up in bonds, may as well hold money as the interest rate is rubbish.

The supply of money is fixed (vertical supply curve), so you get an interest rate determined by the supply and demand for money, if the Bank of England increases the money supply the money supply curve (vertical) shifts right and the interest rate where it intersects the downward sloping money demand curve falls, if it decreases the money supply the money supply curve shifts left and the interest rate rises.

Government borrowing will increase the interest rate independently of that, think of it as putting upward pressure on interest rates so if the Bank of England wants to counter it it will have to increase the money supply. This kind of monetary policy can to keep interest rates in check to a point, if government borrowing increases, but the trade off will be it will cause inflation eventually because if you aren't increasing the amount of goods and services being produced in a society as fast as you are increasing the money supply then that will just mean prices rise.

[quint101]

(Original post by MagicNMedicine)
Yes the rising interest rate is basically just the fall in the price of bonds (see my explanation above about it being inversely proportional). The more government is borrowing, the more bonds it is issuing (as that is how it borrows its money, by selling bonds for cash now that it redeems later, the difference between the redemption price and what it gets now from the buyer will determine the rate of interest when you take into account the time between now and redemption).

The MPC influences the interest rate through controlling the money supply. Money is useful because it can be used for transactions but it does not bear interest if you hold it, whereas holding assets like bonds bear interest but you can't use them for transactions, you have to sell them and convert them into cash first. So there will be a downward sloping demand for money, when bonds bear high interest the demand for money will be low but when bonds bear low interest the demand for money will be high. This is because when interest rates are high people will store a bigger proportion of their wealth in bonds (to get the interest) and forego spending now, in practice if you hold money in some form of savings account the bank buys bonds on your behalf so this is effectively like holding bonds. But this is less convenient than holding money as you can't access savings to spend on transactions straight away, you have to sell the bonds first (hence savings accounts at banks being not usually 'immediate access' to the depositor). So when interest rates are low you would just say there's no point tying my wealth up in bonds, may as well hold money as the interest rate is rubbish.

The supply of money is fixed (vertical supply curve), so you get an interest rate determined by the supply and demand for money, if the Bank of England increases the money supply the money supply curve (vertical) shifts right and the interest rate where it intersects the downward sloping money demand curve falls, if it decreases the money supply the money supply curve shifts left and the interest rate rises.

Government borrowing will increase the interest rate independently of that, think of it as putting upward pressure on interest rates so if the Bank of England wants to counter it it will have to increase the money supply. This kind of monetary policy can to keep interest rates in check to a point, if government borrowing increases, but the trade off will be it will cause inflation eventually because if you aren't increasing the amount of goods and services being produced in a society as fast as you are increasing the money supply then that will just mean prices rise.

Thanks again, all the above makes more sense now. I have another question, slightly unrelated to the above topics: what is the differene between central bank base interest rate and the repo rate? The online definitions are quite similar, so is there a differene? Sorry for all the questions!