Bonds and Bond Derivatives, Second Edition

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DETERMINANTS OF THE LEVEL OF INTEREST RATES

While many varieties of debt instruments exist, all debt instruments are affected by macroeconomic factors determining the underlying interest rate. This chapter discusses macroeconomic factors affecting interest rates. The first part discusses the Federal Reserve and its impact on rates. Next, the loanable funds approach shows the impact of the supply of, and demand for, funds on interest rates. The impact of inflation is the focus of the last part of the chapter.

Federal Reserve

The Federal Reserve is the central bank of the United States. The major function of the Federal Reserve in the bond market is to set and administer monetary policy. This involves controlling the money supply and/or interest rates.

The Federal Reserve system consists of two major parts: the Board of Governors in Washington, DC, and the 12 Federal Reserve district banks and branches. The Federal Reserve Board is composed of seven members appointed by the President for 14-year terms. The terms are staggered so that a new governor must be appointed every 2 years. One of the governors is appointed by the President as Chairman of the Board of Governors for a 4-year term. In practice, the Chairman has considerable power in setting the course of monetary policy.

The Federal Reserve system is composed of 12 districts, each of which has a Federal Reserve district bank and branches. These Federal Reserve banks are privately owned by the commercial banks that are Federal ...