December 1, 2022

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This is the calculation behind interest rates

This is the calculation behind interest rates

Behind Central Bank Governor Edda Walden Bashi is an army of economists and mathematicians who keep a close eye on developments in the Norwegian economy. This week, they raised the key interest rate by 0.25 percentage points to 2.5 percent. This is the sixth rate increase since September last year.

When the central bank has to set the key rate, they have advanced mathematical tools as aid called NEMO (Norwegian Economic Model), explains mathematics professor Fred Espen Benthe at the University of Oslo (UiO).

Economists use NEMO to see what they can do to keep the value of money stable. The most important help they have is the prime rate.

In short, this is the NEMO mission: What are the key interest rates so that money has an equal value? It is unfortunate that money loses a lot (inflation) or goes up a lot (deflation) in a short time. The goal is constant inflation of 2 percent. High interest rates can be boring, but it’s even worse if you wake up one day and the money you had in the bank yesterday didn’t have enough value to buy today’s loaf of bread. It is therefore important to keep price increases under control.

The model is described as the “new Keynesian DSGE model”.

The acronym hides three components: the equilibrium model (general equilibrium), dynamic (dynamic) and acronym (randomization), Benth explains.

Balance between supply and demand

In macroeconomics, one studies how wages, interest rates, inflation, prices, exchange rates, production of goods, demand, imports and exports are related.

You set up mathematical equations of how different factors affect each other and look at the equilibrium, so that supply equals demand, Benth explains.

He explains equilibrium with an example: If restaurant prices go up, demand goes down. As a result, some restaurants go bankrupt, and the supply of nightlife is diminishing. Balance takes place. This balance is encapsulated in NEMO.

Expectations for the future are dynamic

All the different factors in NEMO change over time.

For example, your salary and mine will be determined by what we have today and what our expectations are for the future, says Benth.

It shows that wage expectations are often related to price growth or price growth expectations. So mathematicians must make future predictions and at the same time make sure that the number of predictions changes over time.

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All factors included in the equilibrium model have a time parameter associated with them, such that they change over time, usually in quarterly increments, says Benth.

Not even mathematicians can predict the future

The biggest problem is that the future itself is an uncertain factor. Expectations are not always met, hence this must also be included in the model.

It has been realized that the world is a little more complex than the dynamic models we assume of inflation, interest rates, wages, unemployment, and so on. Benth says we simply add a small random component that varies randomly.

The fact that something varies randomly means that it is random. Bennett explains this with an example: Imagine you have a model of what the bank’s interest rates will be tomorrow. In this model, the possibility has been added that the interest rate might be something different than what it is supposed to be. This difference is related to how far from expectations the current interest rate is. The interest rate will either start above expectations and move toward equilibrium, or start below expectations and move toward equilibrium.

“In fact, the interest rate can also jump a little bit randomly up and down, and then we say we have a random variable that can push the interest rate up or down a little bit, quite arbitrarily,” Benth explains. It’s a bit like tossing a coin or coin, the outcome should be random.



What should be included?

– The problem of the economists is; What macroeconomic factors should be included in the model? Bennett explains that to create good dynamic models for these factors includes chance and finding model parameters by analyzing historical data.

According to Bent, the analysis of history is “history in itself”. However, the point is that this complex mathematics depends on what we humans put into it. So what factors should go into the model?

Norges Bank: This affects the interest rate

According to the Bank of Norway Third Monetary Policy Report 2022 They are the following driving forces that raise interest rates: price growth, wage increases, oil prices and investments.

The factors that reduce the rate of interest are the demand for goods and services within Norway’s borders, exchange rates, an increase in the prices of imported goods, and a somewhat lower demand for Norwegian goods abroad, with the exception of oil and gas.

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The most important factor is price growth, and it may seem counterintuitive that higher interest rates will help reduce this. But: In today’s market, part of the reason for the price hike is that there are so few things for sale — a large portion of the resources go to war, and some production has gone down after the pandemic. When there are few things to sell compared to demand, prices go up.

The Bank of Norway should prevent people from spending money, says Benth.

The bank should prevent people from shopping

The central bank cannot supply more goods, so the only way to control rising prices is to reduce demand. In other words, we have to have less money to spend on goods and services.

In pure theory, it might be possible to roll back quotas or other methods of limiting people’s opportunities to trade, but the current method is to set the prime rate.

Banks borrow or deposit their money in the Bank of Norway. When Norges Bank changes the key rate, the banks will have to change the interest rate with their customers again.

The current government promised that “it’s the turn of ordinary people” to increase purchasing power. The problem is that if the government actually promised to do so, interest rates would go up even more because the whole point of raising interest rates is to reduce purchasing power. The interest rate will likely continue to rise until most people reduce demand.



High loan can ‘disappear’ due to high rate hike

If you have a high mortgage, the current situation can feel hopeless, but mathematically speaking, it’s not just a shame that the price increase is high. Interest is the bank’s income, but it also has another function.

Interest is what we pay for the loan, but it is also what we must deduct future amounts from. What is the value of a million in the future today? On average, inflation can suddenly become 4 percent, and then the value of a million becomes less, Benth explains.

To discount something, you must take into account that the value changes over time. If we have a steady increase in prices, it is possible to determine the value of your money in the future. Bennett explains this by saying that at one time crown ice cost a kroner, although it is about 30 times more expensive today.

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– With the help of the discount, it is possible to calculate the cost of krone ice in the future, says Benth. Banks do this with mortgages. What is interesting is that if the price increase is too high, this change can “eat up” the loan.

deflation ghost

Most economists do not seem to be too concerned about price increases as they can often be controlled by raising interest rates. In turn, they fear the opposite of inflation, that is, deflation. This means that demand drops so much that prices are collapsing.

Something like this could happen to the cottage market, where many have bought cottages that they may not be able to use when electricity is too expensive, Benth explains.

He adds that this is not something he is afraid of in the market in general, but that some commodities may experience a temporary drop in prices.

– If you know that there is deflation and housing prices are declining: why buy a house today? Then I’ll wait and save money instead. Generally, when prices fall, more people are willing to sell than buy. Benth says it is unfavorable.

Inflation is fundamental to capitalism

Since economists are more afraid of a market crash, the entire system is geared toward weak growth.

Inflation is a general and absolutely essential growth of capitalism. Benth explains that we’re getting a little better, a little more efficient, and we’re getting more to work with each year. Inflation is a type of measure of growth in a society. Prices go up a little bit because someone does a better job and we get a little bit better products. But he concludes that it is important that the growth is not too fast, because “money devours itself.”

source:

Norges Bank, Monetary Policy Report 3/2022, September 22, 2022

The article was first published in Titan.uio.no