Abstract
Increasing interest rate is a contraction monetary policy which affects the cost and availability of credits. The increase of interest rate in China is likely to affect the aggregate consumption, price of bonds, level of investment and employment in a country. The effect on investment and employment is supposed to take considerable period of time. This is because they can only be affected through the accelerator principle. The central bank of china increased interest rate to counter inflation. However, this move may not affect the inflation rate as expected due to massive capital inflows.
The move is expected to influence the way of carrying business as well as bringing new business opportunities and making others non viable. The manufacture and sale of basic commodities is a viable business opportunity because these commodities face inelastic demand.
Introduction
Interest rate is the amount lenders wish to be compensated for allowing investors to use their money. Increasing interest rate therefore increases the cost of credit in the economy. Availability of credit is geared at affecting aggregate demand within the economy. In this case, aggregate demand refers to the total demand for goods and services in a country. Therefore, lowering aggregate demands avoids demand pull inflation. The move is quite complicated in china given that the country is experiencing massive capital inflow.
Effect of interest rates on manufacturing and in basic commodities
Interest rate is essential in determining level of inflation in a country, but, extend of its effectiveness varies from one country to another. The interest rate also affects level of investment and employment, but, the effect is not direct. However, its effectiveness to influence the two depends on other economic factors like capital inflows.
Monetary policies are put in place to control the amount of money in circulation and tame inflation. Interest rate is one of the main monetary policies used by central bank of a country to regulate borrowing and saving in the economy.
The above table shows that every year interest rate raised the cost of investment raised in turn. This is because the cost of capital increased meaning that one has to spend more in initiating a project in china. 2The current rates are at 6.06% increased from the previous rates of 5.81% raising the cost of investment.3 It is clear that the decline on level, due to increased investment costs, will in turn lower employment level hence people demand will below.
Changes in interest rate definitely affect public demand for services and good hence, new business opportunities surface. This is because of changes in borrowing cost, availability of credit (bank loans), foreign exchange rates and wealth of households. Many people will be willing to save if interest rate offered is high. This means that people tend to forego present consumption for future consumption. Consequently, decision of foregoing present consumption or consuming today affects the level of buffer stock. The level of buffer stock determines the level of production and storage costs i.e. when the firms are not selling; it means that they reduce production. While, altering production affects the level of employment. This is a simple description which shows the effect of altering inflation in a closed economy. It has clearly indicated a time lag for the whole economy to adjust to monetary policy of altering interest rate. This clearly portrays that it takes considerable duration before a monetary policy of changing interest rate affect the inflation rate and economy. This time lag can vary e.g. the effect on output can take more than four months, while on inflation the effect can take more duration as well as changes in the price level (Federal Reserve Bank of San Francisco, 2010).
The monetary policy forces business people to change perspective of conducting business. This is because business people are forced to diversify their business to evade loss of revenues resulting from low aggregate demand. New business opportunities emerge such as investing in foreign bureau, increasing imports, investing in basic commodities among other business opportunities.
The contraction monetary policy reduces people’s purchasing power. This means that the general aggregate demand will be low. Therefore people will be forced to avoid spending on luxury products but they cannot minimize the demand for necessities. Therefore the demand of basic commodities will stay high. Basic commodities are items like food, shelter and clothing. These items have inelastic demand meaning that people must spend on them despite their intentions to postpone their present consumption. Therefore even as people speculate future falling prices of these products they keep on purchasing considerable amounts. This means that the short term turnover of this goods and services will not fall as low as that of luxuries. Investing in luxuries will not be a good business idea because people will fore go present consumption of these commodities given that they face elastic demand. Thus, huge investments will follow for basic goods, and as a result the profits will increase due to the high demand.
In midterm, these commodities should be produced in little amount to fit in the declining demand. When producing these necessities always ensure that the inputs are bought at a price which reflects future falling prices. To minimize the production cost on salaries and wages it is advisable to employ workers on short contract. This makes sure that the wages paid to employee reflect the current labor prices in consideration of the future prices. It also makes it possible to avoid cases of paying other type of benefits given that the worker is only temporally employee. Many workers will be willing to get the employment even at low wages given that the level of unemployment in the country will be high.
The local currency (Yuan) is expected to start appreciating in midterm. It is therefore important should consider importation of some inputs which may be cheap in foreign markets, but, this needs continuous comparison of the domestic prices inconsideration of import price and costs such as tariffs and freight charges. This will enable one to sell at a lower price and be very competitive in the market given that consumers have very little amount they wish to consume. This makes one to earn nice profits.
As days go by, it is advisable to increase the number of imported in puts as well as start importing foreign processed basic commodities. Importing foreign produced commodities is advisable because the prices of imports are expected to keep on falling. This is unlike In short run, where purchasing the local inputs and processing them was cheaper because the effect of economic change had not been felt. It will take some time before exchange rates starts changing. It is expected that the Chinese Yuan will start appreciating with time but not immediately. Therefore, when a business person imports foreign commodities, He or she will be competitive in the market. Considering that all Chinese will be considering prices of commodities before purchasing.
This is because they consider foregoing present consumption as they expect the future prices to fall, hence, only a small percentage of their declining income will be available for consumption. The rest will be saved to earn the increasing interest rate.
This is based on the hypothesis that people will always consider the interest rate they can earn out of saving before they consider how much to spent on present consumption. The decision to import will only be viable if the government does not impose unrealistic quotas.
In long run one should rely solely on imported produced goods because the prices of such commodities are expected to be low even when the importation cost is included. This is unlike purchasing local inputs and processing them locally them locally.6 One will really earn high profits when trading on basic commodities in both short run and long run.
Conclusion
The impact of changes in interest rate in the economy influences the consumption habits. This is because the value of Chinese Yuan will change. The aggregate demand fall as people hope future commodity prices will fall. In addition, people will forego present consumption so as to save and earn the additional income resulting from increased interest rate. This will be caused by variation in the level of investment as well as employments because of changes in availability and cost of credit.
It is therefore important for business people to consider investing in manufacturing and sale of basic commodities which have inelastic demand unlike investing in luxuries which face elastic demand. Moreover, the manufacture of the basic commodities will only be applicable in short run in midterm consider purchasing imported inputs while in long run do not manufacture products but rather buy foreign processed commodities because they will be very cheap. On the other hand, investing in foreign exchange bureau is a noble idea given that speculative demand for money will be in a constant state of change. This is because chine’s Yuan is expected to appreciate in long run. The new business opportunity is therefore viable in both short and long run if the mention guidelines are followed to the late
