Input-Output theory of interest rates (The)
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Extant theories of interest rates seek to determine of the level of the interest rate without reference to the structure of interest rates. In contrast, this paper proposes a unified theory of the level and structure of interest rates. The unified theory is based on the simple idea that banks “produce” loans of different maturities from deposits of different maturities by providing the minimum prudential reserves to maintain their solvency while maximizing profitability. The optimal assignment of deposits to loans results in a system of equations (which is formally identical to the Leontief price system) that determines a unique positive solution for the structure of interest rates that banks must quote. Interest rate quotations thus derived normally exhibit their usual upward slopes but can become perverse in economic circumstances that require banks to meet short-term loan demand from their long-term deposits. Generalisations of the basic theory to cover issues like the pricing of default risks, determination of interest rate spreads and the effects of monetary policy have been discussed.
- GIPE Working Papers