Recently, there has been much public discussion about a high-interest rate policy versus a low-interest rate policy with some commentators declaring that the time is right to shift from a high-interest rate policy to a policy of low interest rate. Unfortunately, this discussion is taking place with little appreciation of the principles of economics.

Every first-year economics student is taught that no buyer or seller, by himself, can choose both the price and the quantity traded at the same time, regardless of whether he is the sole buyer or seller. If either the buyer or the seller has the power to set price, and chooses to do so, then the market will determine the quantity sold. Alternatively, if the buyer or the seller is sufficiently powerful to determine the quantity sold, and chooses to so determine, then the market will determine the price.

Interest rate is a price, like any other price. It is the price which the borrower must pay to the lender for the use of the lender's money for a specified period of time. Likewise, it is the reward which the lender receives for forgoing the use of her money for a specified time period. The interest rate is, therefore, the price of money. The rules which apply to price formation of any other good or service also apply to the price of money.

The Government through the Ministry of Finance is a major player in the market for money, and therefore impacts the market conditions for money. We need to understand why the Ministry of Finance enters the money market in the first place. The answer is simple; it does not raise sufficient revenue from taxation to cover its expenditure and so must borrow to fill the gap, which is known as the Budget deficit. The Government, therefore, enters the market with the intent of borrowing a fixed quantity of money; it is, therefore, fixing the quantity to be traded.

Having fixed the quantity to be traded, it cannot simultaneously fix the price (i.e. the interest rate). Once the Government has indicated how much money it seeks to borrow, the market will then determine what interest rate will induce people to lend this quantum of money to the Government.

Borrowing less

People should not think that because the Government announces an interest rate, it is in fact setting the interest rate. An auctioneer announces prices, but is he really setting prices? The answer is no. The announcement only becomes a relevant price when both a buyer and a seller accept that price. It, therefore, matters little who announces prices. If I declared a price of $100 million for my house, and no one is willing to pay this price, can I truly say that the price of my house is $100 million? If the Government announces an interest rate which it is willing to pay, and people are not willing to lend it sufficient money at that rate to meet its target, what happens next? Either the Government must decide to borrow less or it must raise the interest rate to induce more people to lend. Borrowing less means either collecting more taxes and/or reducing government expenditure.

What is it that influences people as to the interest rate which they should accept in lending their money to the government (or anyone else for that matter)? Before answering this question we need to establish three concepts - nominal interest rate, real interest rate and the rate of inflation. Nominal interest rate is simply the interest rate expressed in numeric form with little reference to anything else. Most of the times when the interest rate is spoken of, it is the nominal interest rate which is mentioned. Examples of a nominal interest rate would be 20 per cent on government bonds or 18 per cent for mortgages, etc. The real interest rate is a measure of increase purchasing power which the lender obtains when he is repaid, compared to what he had at the time of making the loan. The rate of inflation measures the rate of increase in prices in general. The real interest rate is approximately equal to the nominal interest rate minus the inflation rate. If the nominal interest rate is 20 per cent and the rate of inflation is 15 per cent, then the real interest rate is approximately five per cent, that is, a lender who lent a sum of money a year ago at 20 per cent and who is repaid today with inflation being 15 per cent, could buy five per cent more things with her money than when she lent it.

If a lender lends money at less than the rate of inflation, when she is repaid, she will be able to buy less than she could have before lending the money. No lender would, therefore, want to lend money at a nominal rate of interest below the rate of inflation. The rate of inflation is therefore a floor for the nominal rate of interest that people would be willing to accept for lending their money. In fact, most people would want to be positively compensated for the sacrifice of parting with their money for a time, therefore, they want a nominal rate of interest above the inflation rate.

People, in lending their money, must make a guess as to what they think the rate of inflation will be. They use the past to inform their decision, but not only the past. If they have experienced inflation of 15 per cent for 10 years and then the inflation rate drops to 10 per cent what are they to think about the inflation rate going forward? Are they to say that from now on the inflation rate will be 10 per cent or are they to think that the 10 per cent was a fluke and the country will return to 15 per cent?

Inflation

Obviously, the more years that the country experiences 10 per cent inflation the more confidence people will have in the next inflation rate being closer to 10 per cent than to 15 per cent. People also look at other economic fundaments such as the size of the government's fiscal deficit in forming their expectations about what the future rate of inflation will be, and therefore what the inherent risks in lending money to the government.

Any man who has wooed a lady, knows that no single action is sufficient to convince her of his affection. Furthermore, even after he has convinced her of his past affection, he must continue to reassure her of his future affection. So it is with financial markets, the Government has constantly to re-assure lenders, not so much about the past (although this is important), but more so about the future, if they are to accept lower interest rates.

The central bank is also a player in the money market. Its role is, however, very different from that of the treasury. The primary objective of the central bank is the protection of the value of the currency. An important part of that mandate is to protect the health of the banking sector. If the central bank deems that there is too much local currency, chasing too few good, it will seek to take some of this local currency out of circulation. It seeks to induce people not to spend their local currency but instead lend it to the central bank which they simply sit on. If this is not done, then this excess of local currency will cause inflation to rise, either directly by bidding up the prices of all goods and services available in Jamaica, or indirectly by causing the exchange rate to depreciate. The central bank is targeting a given quantity of money to be removed from the economy, and, therefore, has little control over the interest rate that will be required to achieve this task.

The Ministry of Finance is also concerned with the exchange rate. Approximately 45 per cent of Jamaica's total public debt is external debt (i.e. denominated in foreign currency). A depreciation of the Jamaican dollar causes this portion of the debt to become more expensive in Jamaican dollar terms. At the end of September, the external debt stock was US$6.6 billion. At that time the exchange rate was US$ 1 = J$89.08. The last day of November started with an exchange rate of US$1 = $89.64. This depreciation alone has added $3.7 billion to the external debt stock.

Foreign lenders are equally concerned with the same issues as local lenders and more. They are concerned about the country's ability to repay in foreign currency; therefore, the balance of payments situation is of grave concern to them. Concessional loans, i.e., loans below market rates, provide some reprieve, but the country needs to understand that these are only temporary and are possible only because of taxes of people in the developed world. I concede that debt-servicing concerns are not the only consideration for the exchange rate, but it is a very important one. A deficit in the balance of trade is not unconnected to a deficit in the fiscal accounts of the government. An economy is like a balloon, apply pressure in one area, expect to see a bulge in another.

History is filled with examples of political directorates being very reckless with money creation and monetary policy in general. Various countries have sought to use different institutional arrangements to curtail the power of the political directorate to misuse monetary policy. One extreme measure would be to dollarise, i.e. to abandon the local currency and replace it with the US dollar. By so doing, the country would abandon any pretence to having control over monetary policy instead importing the monetary policy of the United States.

Many countries in addressing this issue have sought to have an independent central bank. Many voices in Jamaica, for a long time, have joined the international trend by calling for an independent central bank. If fact, the ruling Jamaica Labour Party included in its 1997 election manifesto the creation of an independent central bank. But what really does an independent central bank mean? An independent central bank means that the political directorate cedes control of monetary policy to the central bank.

Economic growth

The central bank is given a single mandate - protect the value of the currency. This means that the central bank will not concern itself with economic growth, with employment levels or any other objective. If the central bank has more than one objective it will be forced from time to time to make trade-offs in the pursuit of these different objectives, a task which properly should be taken by elected officials.

The reason that many countries have gone in the direction of an independent central bank is that they are of the view that the value of the currency and by extension the financial system is simply too important to be left to politicians and that society is best served by having experts control this sphere. Jamaica is yet to take a decision on establishing an independent central bank. If it however, makes this decision, it must stand by the decisions of the central bank on monetary policy even when such decisions are not to the liking of the Government of the day.

Some commentators have declared that the elected government should get what the elected government wants. If the society holds this view, then it should abandon any pretence of establishing independent institutions which seek to constrain the power of the government.

Peter-John Gordon is an economist. Feedback may be sent to columns@ gleanerjm.com.