In the simple macroeconomic model of the preceding chapter, the domestic interest rate was an exogenous policy variable determined by the central bank. It affected aggregate demand through private absorption: a lower domestic interest rate was assumed to increase absorption and a higher one to reduce it. But the model did not contain an explanation of how the central bank set the domestic interest rate. Our task in this chapter is therefore to explain how the domestic interest rate is determined. As we will see, the central bank may not always be able to determine the domestic interest rate; it may not always choose to do so; and even when it can, it does not control the domestic interest rate directly but only indirectly through other policy instruments. This means that setting the domestic interest rate at a policy-determined level may be a tricky proposition, requiring the central bank to engage in a delicate balancing act in which it uses its policy levers to compensate for a variety of exogenous factors that would affect the interest rate in the absence of central-bank action. This chapter will explore how the equilibrium value of the domestic interest rate is affected both by the central bank's policy levers and by such exogenous factors.

In the real world, of course, there are a large number of different interest rates in any country, associated with the different types of assets that may exist at any one time in that country's economy.