The Sensitivity of Interest Rates to Changes in Money and Income

Abstract

Changes in interest rates may be attributed to changes in the supply schedule of funds, changes in the demand schedule, or changes in both schedules. Since interest rates link the financial and real sectors of the economy and thus transmit the major thrust of central bank actions to the ultimate targets of monetary policy, it is important to identify properly the causes underlying changes in rates. An increase in rates resulting from an upward shift in the demand fot funds has substantially different implications for the course of economic activity than an equal rise attributable to a downward shift in the supply of funds. This paper conducts tests to determine whether postwar changes in interest rates have resulted primarily from changes in the demand for funds or in the supply of funds. As a first approximation, interest rates can be assumed to be affected on the supply side primarily by the supply of money and on the demand side primarily by aggregate income or output. We can test the relative strengths of money and output on rates by including them both as explanatory variables in one equation1: