Every six weeks or so, the financial news spends several days anticipating the announcement of the Federal Reserve's short-term interest-rate target and, once it has been announced, several days dissecting its policy implications. Whenever long-term bond rates rise or fall significantly, again it is a matter for intense financial commentary. Why? The short answer is that for anyone who borrows money to pay for college, buy a car, a digital camera, or any other good, every rise in interest rates makes things a little bit tighter, and every fall a little bit easier. A significant drop in mortgage interest rates can start a boom, not only in the real estate market but also in anything that might be financed with a home-equity loan. And equally, any significant rise can quickly cool these markets off. It is vitally important to macroeconomics to understand how interest rates behave: What determines their levels? What makes them change?
Five Questions about Interest Rates
Look at Figure 7.1, which shows the time series of five rates of interest: a short government rate (the 3-month Treasury-bill rate); a short private-sector rate (the 3-month commercial-paper rate); a long government rate (the 10-year Treasury bond rate); and two long private-sector rates for corporations with different degrees of riskiness (the Moody's Aaa and Baa bond rates). (The time series are a tangled skein, making the figure a little hard to read. But, as we shall see, the tangles themselves reflect an important fact about interest rates.) These five rates are chosen to represent the thousands of interest rates that are reported regularly. These thousands themselves represent the countless rates (one for each loan or debt instrument) recorded in the history of the economy. The figure reveals several consistent patterns in the interrelationships of the different rates and suggests at least five questions.