Abstract
The US economy thrives on the proper functioning of the monetary policy of the government of the day. Interest rates, inflation and recession are all related and happen to influence proper functions of the government warranting their clear understanding. As a victim of a recent economic recession, a consideration of the role of interest rates on the overall functioning of the economy becomes particularly important.
This paper shall seek to understand the concept of interest rates and how they affect the economy of the United States of America. The paper, in doing this, shall consider the causes of the ever changing interest rates, the players involved in their change as well as how the government can remedy the situation by analysing the role of the government agency charged with this mandate, the Federal Reserve board.
Aside from the effect of the interest rates on the entire economy, the paper shall, in part, consider the effect of the interest rates on the other important sectors of the economy namely: the effect of interest rates on the stock and bonds market and inflation. The final part of the paper shall comprise of a conclusion of the findings of the author as regarding the overall understanding of the effect of the interest rates on the wholesome functioning of the United States’ economy.
Introduction
Interest rates is the cost a borrower usually have to pay to acquire ability to spend now as opposed to having to wait to save up enough for their desires. Similarly, it can be viewed as the reward the lender demands for undertaking the risk of giving the money since it may never be paid back or that by the time it is paid back, the cost of goods and services may have gone up due to inflation.
Performance of the economy the world over is a factor of various economic indicators in the country among them the interest rates, gross domestic product, and the inflation levels (Romer & Romer 2000). Interest rates, as a factor of borrowing from banks and other financial institutions as well as lending, affects how business is conducted in the economy in a variety of ways ranging from affecting the flow of money in the economy to influencing the consumer purchase ability. Moreover, interest rates influence directly and indirectly the prices of commodities which ultimately affects the inflation and consequently the consumer surplus (Akram 2009). Overall, the performance of any economy is a result of the flow of money in that economy as well as ability by buyers to consume what is produced. The effect of interest rates on these market determinants is analysed in more detailed manner later in this paper.
The Role of the Federal Reserve Board
The Federal Reserve board undertakes the necessary actions in the name of monetary policy to stabilize the economy through engagement in measures that either increase the money supply in the economy or ones that decrease the money supply in the said economy. When the board causes the money to increase in the economy, this is referred to as an expansionary monetary policy while that which causes the amount of money in supply to go down is referred to as a contractionary monetary policy (www.federalreserve.gov, 2016). The board achieves the above through counteractive measures that respond to how the economy is performing. For example, when there is a need to either depress or kick start the economy, the board increases or decreases the money supply in the economy through any of the following three major actions: open market operations, discount rate and Federal Reserve requirements.
Through open market operations, the Federal Reserve raises the reserve supply which translates into low interest rates and the reverse is done when the board wants to depress the economy a little. The board could for example offer attractive rates for bonds which translates into a mop up of excess liquidity from the public which depresses their spending through limiting the total amount of money in circulation in the economy (www.federalreserve.gov, 2016). The reverse involves the board offering low interest rates for money borrowed which induces a need to spend more since after all the cost of credit is down.
The discount rate, is the rate the central bank charges the deposit-taking institutions that wish to take a short term loan. By setting it high, the Federal Reserve discourages the banks to borrow which in effect reduces the reserve supply thereby raising the interest rates. The reverse involves the Federal Reserve setting it lower to encourage banks to borrow. This increases the reserve supply thereby lowering the cost of credit or the interest rates.
The reserve is the amount of money the central bank requires the banks to maintain for meeting their day-to-day requirements. By setting it low, the Federal Reserve reduces the demand for banks to hoard money which translates to a higher amount in circulation in the economy which lowers the need for credit and thus decreases the interest rates. In addition, the Federal Reserve can persuade various participants to act in a certain manner in order to influence certain outcomes in the economy related to money supply and demand (www.federalreserve.gov, 2016). These could, for example, involve closed door meetings with bank executives and empty threats by the Federal Reserve to scare participants in a particular direction.
Causes of change in interest rates
The following are the major determinants of the change in interest rates in any economy
Demand and supply of credit
More like the demand and supply for any other good, the higher the demand for credit is the higher the cost of achieving it and the lower the cost of credit the cheaper it is to afford it. In a similar manner, the higher the supply of credit the lower the cost of it and the reverse applies where the lower the supply, the higher the cost of credit (Derousseau, 2015). The supply of credit in the economy is a factor of several market forces.
Inflation rate
Lenders charge an interest rate as a security measure in the sense that by the time the borrower repays the money, the cost of goods and services shall have increased through inflation (Derousseau, 2015). The higher the projection of the expected raises in the price of goods and services, a factor of inflation, the higher the lender will charge as interest for the loan borrowed.
Government
The government through the Federal Reserve can influence the interest rates based on which monetary policy they exercise. For example, the government may increase the amount of money available to banks for lending through purchase of more securities. The banks can then afford to charge a lower interest rate since they have a huge supply of money.
Type of loans
Since interest rate is basically a payment for the risk that the lender takes in the sense that the loan may never be repaid at all, the higher the risk ascribing to a type of loan, the higher the interest rate for that loan. For example, a loan that is to be paid over a long period of time exhibits a higher risk which in turn leads to a higher interest rate.
Effects of interest rates
Interest rates directly affect several sections of the economy such as inflation and recession, and stocks and bonds market (Derousseau, 2015). The specific way this happens is explained below:
Inflation
Inflation is a disproportionate increase in the prices of commodities in a certain economy over a certain period. The Federal Reserve observes the consumer price index as well as the supply price index to predict the likely course of prices of commodities in the market. When the inflation rate hits beyond the tolerable level of the Federal Reserve board, the Federal Reserve raises the federal funds rate which in turn affects interest rates (Derousseau, 2015). Higher interest rates lowers the availability of credit, depresses consumers spending ability, demand goes down and eventually the prices come down.
Stock and bonds market
When the interest rates go high, the likely response by consumers is that they will cut down sending to avoid a need to acquire the otherwise expensive credit. The result is that earnings for major businesses go down which in turn causes the stock prices to go down (Bullock & Rennison, 2016). As for the bonds, the relationship is inversely proportional in that when the interest rates are down, companies issue bonds to finance their expansion projects which raises the prices for high yielding bonds and the reverse applies.
Economy
When the interest rates are high, the consumers decrease their spending to avoid falling for the high cost of credit. The decreased spending occasions a lag in the economy as the total gross domestic product goes down since it is calculated on the total expenditures of the economy in question. The reverse happens when the interest rates are low. The consumers have more surplus income to spend which causes companies to sell more, employ more and participate in expansion projects which overall jumpstarts the economy (Derousseau, 2015).
Conclusion
References
Akram, Q. F. (2009). Commodity prices, interest rates and the dollar. Energy economics, 31(6), 838-851.
Bullock, N. & Rennison, J. (2016). US stocks and bond yields in record territory due to uncertainty - FT.com. Financial Times. Retrieved 10 July 2016, from http://www.ft.com/cms/s/0/7bff9304-454c-11e6-b22f-79eb4891c97d.html#axzz4E1W63nPd
Derousseau, R. (2015). What the Fed’s Interest Rate Increase Will Mean for You. Fortune. Retrieved 10 July 2016, from http://fortune.com/2015/12/16/feds-rate-hit-you/
Kamal Ahmed, K. (2016). The global impact of the US interest rate rise - BBC News. BBC News. Retrieved 10 July 2016, from http://www.bbc.com/news/business-35114973
Romer, C. D., & Romer, D. H. (2000). Federal Reserve information and the behavior of interest rates (digest summary). American Economic Review, 90(3), 429-457.
www.federalreserve.gov. (2016). FRB: What is the purpose of the Federal Reserve System?. Federalreserve.gov. Retrieved 10 July 2016, from https://www.federalreserve.gov/faqs/about_12594.htm
