Short and Long Term Rates
So far we have discussed interest as if there were only one rate, but there are in fact several rates. It is convenient to divide loans into short and long term loans; it is obviously difficult to say precisely what is a short-term and what a long-term loan but generally speaking we can say that a short-term loan is measured in months duration would be short term and one of ten years long-term. A loan of two or three years duration we may call a medium-term loan. Example of short-term loans are bank overdrafts, day-to-day lending by the banks to the m0ney market and lending to the Treasury by the public in the form of three-month Treasury bills. Examples of long-term loans are long-term issues of Government stock and company debentures.
Long-term rates are usually higher than short-term ones, and the explanation for this is to be found in the factors affecting both demand and supply. A long-term loan is more useful to borrower than a short-term one and he can therefore afford to pay more for it. A three-month loan can be used only as temporary finance, its most common use being to finance the holding of stock. A ten-year loan can be used to finance long term investment such as buildings and machinery. On the other hand a long-term loan is not so advantageous to the lender involving as it does a greater loss of liquidity, consequently higher rates are normally asked for such loans.
There is a close link between long and short term rates of interest. A rise in long-term rates for example will cause a marginal shift of funds from medium-term to long-term, reducing the supply of medium-term capital and raising the medium-term rate. This will in turn attract funds at the margin from the short-term rate. The whole structure of rates tends to move up and down together. For this reason we may simplify our analysis by considering interest as if there were one rate only, though we must not overlook the fact that there are of course several.