interest rate analysis

8/13/2019 Interest Rate Analysis

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Political short-term gain: Lowering interest rates can give the economy a short-runboost. Under normal conditions, most economists think a cut in interest rates will only

give a short term gain in economic activity that will soon be offset by inflation. The

quick boost can influence elections. Most economists advocate independent central

banks to limit the influence of politics on interest rates.

Deferred consumption: When money is loaned the lender delays spending themoney on consumption goods. Since according to time preference theory people

prefer goods now to goods later, in a free market there will be a positive interest rate.

Inflationary expectations: Most economies generally exhibit inflation, meaning agiven amount of money buys fewer goods in the future than it will now. The borrower

needs to compensate the lender for this.

Alternative investments: The lender has a choice between using his money indifferent investments. If he chooses one, he forgoes the returns from all the others.

Different investments effectively compete for funds.

Risks of investment: There is always a risk that the borrower will go bankrupt,abscond, or otherwise default on the loan. This means that a lender generally charges

a risk premium to ensure that, across his investments, he is compensated for those that

fail.

HOW DO INTEREST RATE CHANGES AFFECT THE ECONOMY?

As the central bank raises or lowers short-term interest rates, banks may raise or lower the

interest rates they charge borrowers, including the prime rate. Changes in the prime rate may

affect:

Individually. Banks use the prime rate to set rates for credit cards and consumer

loans. If you have an adjustable-rate mortgage or a credit card that has a rate tied tothe prime rate, payments may rise or fall according to the prime rate.

The whole economy. A change in the prime rate may affect the overall economy in

several ways. For example, an increase may result in fewer consumers taking auto

loans, which in turn may cause a slowdown in the automobile industry. On the other

hand, when interest rates fall, businesses find it easier to finance expansion and other

activities. Typically, increases in interest rates slow economic growth because

consumers have less money to spend and less motivation to borrow. Conversely, if

interest rates drop, the economy may benefit from increased spending.


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o The economy can be influenced easily by interest rates. When interest ratesare high, people do not want to take loans out from the bank because it is more

difficult to pay the loans back, and the number of purchases ofcars and homes

goes down. The opposite is also true.

o The effects of a lower interest rate on the economy are very beneficial for theconsumer. When interest rates are low, people are more likely to take loans

out of the bank in order to pay for things like houses and cars. When the

market for those things gets strong, price decreases and more people can

purchases these things. This also bodes well for investors, who perceive less

risk in taking out a loan and investing it in something because they would have

to pay less back to the bank.

o When people do not have to spend as much money on bank payments, theyhave more disposable income to put toward things they want to purchase.

Suddenly, a trip to the ice cream store is not so much of a budget crunch and a

weekend at the spa seems more doable. These effects, although certainly not

direct, are enough to stimulate the market when interest rates are low.

o Low interest rates are not beneficial for lenders, who are seeing less of a returnon their loan than in times when interest rates are high. This means that banks

may find themselves having to lower the interest rates accrued on money

deposited in the bank in order to maintain a steady profit. However, interest

rates do not really have an effect on how much people save, because an

increased amount of disposable income means that they are more likely to

spend it than to save it.

o When interest rates increase, though, foreign investment can increase becausepeople outside of the country want a larger return for their investment and they

are more likely to get it in a state of high interest rates. This causes more

demand for the dollar, driving up its value in the international market. The

opposite happens, though, when the interest rates are decreased.

EFFECT OF RISING INTEREST RATES

Higher interest rates have various economic effects:
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1. Increases the cost of borrowing. Interest payments on credit cards and loans are moreexpensive. Therefore this discourages people from borrowing and saving. People who already

have loans will have less disposable income because they spend more on interest payments.

Therefore other areas of consumption will fall.

2. Increase in mortgage interest payments.Related to the first point is the fact that interestpayments on variable mortgages will increase. This will have a big impact on consumer

spending. This is because a 0. 5% increase in interest rates can increase the cost of an Rs.100,

000 mortgages by Rs.60 per month. This is a significant impact on personal disposable

income.

3. Increased incentive to save rather than spend. Higher interest rates make it more attractiveto save in a deposit account because of the interest gained.

4. Rising interest rates affect both consumers and firms . Therefore the economy is likely toexperience falls in consumption and investment.

5. Reduced Confidence. Interest rates have an effect on consumer and business confidence. Arise in interest rates discourages investment; it makes firms and consumers less willing to

take out risky investments and purchases.

EFFECT OF LOWER INTEREST RATES

If the Central Bank reduces the base interest rate, this will usually cause commercial banks to

reduce their own interest rates. Lower interest rates in the economy will:

Reduce the incentive to save. Lower interest rates give a smaller return from saving. Thislower incentive to save will encourage consumers to spend rather than hold onto money.

Cheaper Borrowing costs.Lower interest rates make the cost of borrowing cheaper. It willencourage consumers and firms to take out loans to finance greater spending and investment.

Lower mortgage interest payments. A fall in interest rates will reduce the monthly cost ofmortgage repayments. This will leave householders with more disposable income and should

cause a rise in consumer spending.

Rising Asset Prices. Lower interest rates make it more attractive to buy assets such ashousing. This will cause rise in house prices and therefore rise in wealth. Increased wealth

will also encourage consumer spending as confidence will be higher. (wealth effect)

Depreciation in the Exchange Rate. A lower interest rate makes it relatively less attractive tosave money in that country. Therefore there will be less demand for the currency causing a
http://econ.economicshelp.org/2009/10/economic-wealth-effect.htmlhttp://econ.economicshelp.org/2009/10/economic-wealth-effect.html


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fall in its value. A fall in the exchange rate makes exports more competitive and imports

more expensive. This leads to an increase in AD.

Evaluation

It affects people in different ways.The effect of higher interest rates does not affecteach consumer equally. Those consumers with large mortgages will be

disproportionately affected by rising interest rates. For example, reducing inflation

may require interest rates to rise to a level that cause real hardship to those with large

mortgages. This makes monetary policy less effective as a macroeconomic tool.

Time lags.The effect of rising interest rates can often take up to 18 months to have aneffect. For example if you have an investment project 50% completed, you are likelyto finish it off. However, the higher interest rates may discourage starting a new

project in the next year.

It depends upon other variables in the economy.At times, a rise in interest ratesmay have less impact on reducing the growth of consumer spending. For example, if

house prices continue to rise very quickly, people may feel that there is a real

incentive to keep spending despite the rise in interest rates.

Real Interest Rate. It is worth bearing in mind that what is important is the realinterest rate. The real interest rate is nominal interest rates minus inflation. Thus if

interest rates rose from 5% to 6% but inflation rose from 2% to 5.5 %. This actually

represents a cut in real interest rates from 3% (5-2) to 0.5% (6-5.5) Thus in this

circumstance the rise in nominal interest rates actually represents expansionary

monetary policy.

BIBLIOGRAPHY

o http://www.economicshelp.org/blog/3417/interest-rates/effect-of-lower-interest-rates/o http://www.investopedia.com/ask/answers/03/112003.aspo http://en.wikipedia.org/wiki/Interest_rate#Zero_interest_rate_policy


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o http://benefits.northropgrumman.com/_layouts/NG.Ben/Pages/AnnouncementReader.aspx?w=B9F17B39-24B3-4958-A0EA-FE0C7835F43E&l=489D0D55-D3E7-4BB9-A8AD-

FA1CC3D56EF1&i=5

o http://www.economicshelp.org/macroeconomics/monetary-policy/effect-raising-interest-rates/

o http://www.economist.com/blogs/buttonwood/2013/02/investing

interest rate analysis

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