CHAPTER 7: INTEREST RATE

Interest rate good things or bad things?

The economy is a living, breathing, deeply interconnected system. When the Fed changes the
interest rates at which banks borrow money, those changes get passed on to the rest of the
economy.

For example, if the Fed lowers the federal funds rate, then banks can borrow money for less. In turn,
they can lower the interest rates they charge to individual borrowers, making their loans more
attractive and competitive. If an individual was thinking about buying a home or a car, and the
interest rates suddenly go down, he or she might decide to take out a loan and spend, spend, spend!
The more consumers spend, the more the economy grows.

Effect of raising interest rates

The primary interest rate (base rate) is set by the Bank of England / Federal Reserve. If the Central
Bank is worried that inflation is likely to increase, then they may decide to increase interest rates to
reduce demand and reduce the rate of economic growth.

Usually, if the Central Bank increase base rates, it will lead to higher commercial rates too.

Higher interest rates have various economic effects:

1. Increases the cost of borrowing. With higher interest rates, interest payments on credit
cards and loans are more expensive. 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 interest
payments on variable mortgages will increase. This will have a significant impact on
consumer spending. This is because a 0. 5% increase in interest rates can increase the cost of
a 100,000 mortgage by 60 per month. This is a significant impact on personal discretionary
income.

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

4. Higher interest rates increase the value of currency (due to hot money flows. Investors are
more likely to save in British banks if UK rates are higher than other countries) A stronger
Pound makes UK exports less competitive reducing exports and increasing imports. This
has the effect of reducing aggregate demand in the economy.

5. Rising interest rates affect both consumers and firms. Therefore the economy is likely to
experience falls in consumption and investment.

6. Government debt interest payments increase. The UK currently pays over 30bn a year on
its national debt. Higher interest rates increase the cost of government interest payments.
This could lead to higher taxes in the future.
 7. Reduced confidence. Interest rates have an effect on consumer and business confidence. A
rise in interest rates discourages investment; it makes firms and consumers less willing to
take out risky investments and purchases.

Therefore, higher interest rates will tend to reduce consumer spending and investment. This will lead
to a fall in Aggregate Demand (AD).

If we get lower AD, then it will tend to cause:

Lower economic growth (even negative growth recession)

Higher unemployment. If output falls, firms will produce fewer goods and therefore will
demand fewer workers.

Improvement in the current account. Higher rates will reduce spending on imports, and the
lower inflation will help improve the competitiveness of exports.

Evaluation of higher interest rates

Higher interest rates affect people in different ways. The effect of higher interest rates does
not affect each consumer equally. Those consumers with large mortgages (often first time
buyers in the 20s and 30s) 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. However, those with savings may actually be better
off. This makes monetary policy less effective as a macro economic tool.

Time lags. The effect of rising interest rates can often take up to 18 months to have an effect.
For example, if you have an investment project 50% completed, you are likely to 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 rates may 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 increase in interest rates.

Real interest rate. It is worth bearing in mind that the real interest rate is most important.
The real interest rate is nominal interest rates minus inflation. Thus if interest rates rose from
5% to 6% but inflation increased 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.

It depends whether increases in the interest rate are passed onto consumers. Banks may
decide to reduce their profit margins and keep commercial rates unchanged.

Increased interest rates 2004-06 had a significant impact on US housing market. Higher mortgage
costs led to a rise in mortgage defaults exacerbated by a high number of sub-prime mortgages in
the housing bubble.

In this case, higher interest rates were a significant factor in bursting the housing bubble and causing
the subsequent credit crunch.
Interest rates and recession

Rising interest rates can cause a recession. The UK has experienced two major recessions, caused by
a sharp rise in interest rates.

Effect of lower interest rates

Tejvan Pettinger August 3, 2016 A-Level, interest-rates

A look at the economic effects of a cut in the Central Bank base rate.

Summary: Lower interest rates make it cheaper to borrow. This tends to encourage spending and
investment. This leads to higher aggregate demand (AD) and economic growth. This increase in AD
may also cause inflationary pressures.

In theory, lower interest rates will:

Reduce the incentive to save. Lower interest rates give a smaller return from saving. This
lower 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 will
encourage 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 of
mortgage 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 as
housing. This will cause a 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. If the UK reduce interest rates, it makes it relatively less
attractive to save money in the UK (you would get a better rate of return in another country).
Therefore there will be less demand for the Pound Sterling causing a fall in its value. A fall in
the exchange rate makes UK exports more competitive and imports more expensive. This
also helps to increase aggregate demand.

If lower interest rates cause a rise in AD, then it will lead to an increase in real GDP (higher
rate of economic growth) and an increase in the inflation rate.

Evaluation of a cut in interest ratesThis shows the cut in interest rates in 2009, was only partially
successful in causing higher economic growth. This is because many other factors were affecting
economic growth apart from interest rates.

Evaluation points

Will interest rate cut be passed on to consumers? If the Central Bank cut the base rate,
banks may not pass this base rate cut onto consumers. For example, in the credit crunch of
2008/09, banks were short of liquidity and keen to encourage more bank deposits.
 Therefore, when interest rates were cut to 0.5%, banks didnt reduce their interest rates very
much so the interest rate cut had little effect on consumers.

It depends on other factors in the economy. Ceteris paribus, a fall in in interest rates should
cause higher economic growth, however there may be other factors that cause the economy
to remain depressed. For example, if there is a global recession then export demand will be
falling and this may outweigh the small increase in consumer spending.

Bank Lending. Interest rates may be low, but banks may be unwilling to lend. e.g. after credit
crunch of 2008, banks reduced the availability of mortgages. Therefore, even if people
wanted to borrow at low interest rates they couldnt because they needed a high deposit.

Consumer Confidence. If interest rates are cut, people may not always want to borrow more.
If confidence is low, a cut in interest rates may not encourage more spending. After 2008, we
saw an increase in the savings ratio (despite interest rate cut) this was because confidence
fell in the great recession.

Deflation. If we had deflation then even if interest rates are very low, then people may still
prefer to save because the effective real interest rate is still quite high.

Time Lag. A cut in interest rates can have up to 18 months to affect the economy. For
example, you may have a two year fixed mortgage deal. Therefore, you are not affected by
the lower interest rate until the end of your two year fixed mortgage term.

Impact on different groups in society

A cut in interest rates will have a different impact on different groups within society.

Lower interest rates are good news for borrowers, homeowners (mortgage holders). This
group may spend more.

Lower interest rates is bad news for savers. For example, retired people may live on their
savings. If interest rates fall, they have lower disposable income and so will probably spend
less.

If a country has a high proportion of savers then lower interest rates will actually reduce the
income of many people. In the UK, we tend to be a nation of borrowers and have high levels
of mortgage debt, therefore cuts in interest rates have a bigger impact in the UK, than EU
countries with a higher proportion of people who rent rather than buy.

Impact on current account

1. On the one hand, lower interest rates encourage consumer spending; therefore there will be
a rise in spending on imports. This will cause a deterioration in the current account.

2. However, lower interest rates should cause a depreciation in the exchange rate. This makes
exports more competitive, and if demand is relatively elastic, the impact of a lower exchange
rate should cause an improvement in the current account. Therefore, it is not certain how
the current account will be affected
determinants

Changes in interest rates structure depend on reasons that are both internal and external to financial
markets:
1. Different types of interest rate are linked and influence each others, so that the functioning of the
financial markets and their international relationships explain a good deal of interest rate
fluctuations.
2. Economic performance, perspective and expectations of potential loan receivers as well as in the
overall economy play an important role.

To keep things easy, we could say that interest rates are determined in negotiations, which are more
or less public, binding a larger or narrower number of contrahents, more or less depending on
publicly available benchmark rates.

In a sentence, interest rates are set within institutional agreements.

Central bank policy is one of the most powerful factor impacting on these agreements, for example
through the instrument of direct determination of official discount rate or the rate for refinancing
operations.

An increase of money offered in the interbank market by the central bank is conducive to a fall in the
interbank rate, upon which many contracts are based.
To the extent the Ministry of Treasury influences the interest rates on its own bonds, it provides an
important reference point for the economy.

Since for many banks the risky commercial loans to firms are alternative to safe Treasury bonds,
there are paradoxically situations in which the interest rate policy in the hands of the Treasury not
less than of the central bank.

International tendencies exert an important influence on domestic conditions as well, since financial
markets are now global in scope and there is a growing co-operation among central banks.
Still, domestic commercial bank policies say the last words on loan agreements and conditions.

In general, an increase of interest rates may be provoked by the following factors alternatively or
cumulatively:
1. an anti-inflationary policy of the central bank, based on restrictions to the growth of the
nominal money supply and on rising discount interest rate;
2. a policy by the central bank aimed at revaluating the currency or defending it from
devaluation,
3. the attempt of the Treasure of covering public deficit by issuing more bonds in an
unwilling market,
4. an attempt of banks of widening their margins, possibly as a reaction to losses,
5. any increase in other interest rates, also foreign rates arisen for whatsoever reason.

By contrast, a fall in interest rates may be justified especially by the following reasons:
1. an expansionary policy of the central bank,
2. the requests of industrialists and trade unions for cheaper money in front of a crisis,
3. a loose monetary policy due to a commitment to a fast export-led growth;
4. the end of an inflationary phase;
5. the relaxation of the need for defending the exchange rate, for example thanks to a new monetary
union.

Impact on other variables

The traditional effects on an increase of interest rates are, among others, the following:
1. a fall in stock exchange and in the value of other assets (as private and Treasury bonds or houses
and real estate);
2. a fall in profitability of firms;
3. a fall in private investment;
4. a fall in consumption credit;
5. an inflow of foreign capital for buying bonds;
6. an upward pressure on exchange rate;
7. a larger public expenditure to pay for a previously cumulated public debt, whose burden might
lead to reduction in other chapters in public expenditure;
8. a narrower disposable income for households having a large debt taken at variable rates;
9. a larger disposable income for households that have lent to others at variable rates (e.g. they own
government bonds with variable rates);
10. a redistribution of income from debtors to lenders (in the part of debt that has variable rates).

3. If the rate is kept higher for a longer period of time, also newly agreed fixed rate instruments
will adjust up.

4. Still, the general environment in which the rise takes place is crucial, since such effects can
be completely absorbed by other (more powerful) forces. A booming economy might
absorbe a small increase in the interest rates possibly well.

5. Similarly, a non-linear relationship could be worth considering between the size of rate
increase and the differentiated effects on real and financial markets.

6. In fact, a small change in the official discount rate might arguably have no real effect at all,
while triggering substantial echos on financial markets.

7. By contrast, a large and abrupt increase in general interest rates can have devasting effects
on crucial real variables, exerting a depressing pressure on GDP and the economy at large. In
particular, if prices in the real estate (including housing) market and Treasury bonds are
falling, their value as collateral for loans would be reduced. The credit crunch would squeeze
private investment. If the business environment is such that the State begins to delay due
payments to firms and has difficulties in re-finacing its debt (with some risk of default, even if
just in long term perspective) banks might be compelled to reduce credit for current business
transactions across the supply chain.

8. A chain of bankruptcies would close down plants, select the surviving firms, and reduce
employment. At the local scale, entire neighbourhoods and towns would economically
collapse, with empty buildings and dismissed industrial estate, looking for a future urban
regeneration.

9. The effects will be spread unevenly across industries, with some being much more
vulnerable. For instance, there is a strong relationship between interest rates and real estate
growth or fall, since all sides of the housing and non-residential market usually leverage debt
 (the purchaser but also the producer of the new real estate). Many sales are inter-linked,
with a purchase made by owners that are able to sell their asset and add only the difference
(or extract it, depending on the difference in prices between the two sales), which further
contributes to the high sensitivity of the sector to interest rates.

10. Long-term trends

11. Interest rates fluctuate over time with an historical ceiling, i.e. a maximum level. Even
though in high-inflation periods the nominal interest rate can reach extremely high levels, for
long decades a ceiling of 10% is a rule for many countries.

12. Nominal interest rates have a minimum floor of zero, with the exception of central bank
interest rate for refinancing operations which can be negative as a part of monetary policies
aimed to stimulate the economy.

13. Business cycle behaviour

14. Interest rates primarily depend on policy and expectations, thus the relationships with the
business cycle depend on explicit decisions and subjective judgements of key players.

15. If the interest rates are mainly used to fine tune the business cycle, then they will fall in
recessions, slightly but steadily rise with recovery and, finally, will be increased at the end
of the growth period to brake possible inflationary dynamics. Soft landing will be targeted,
even though hard landing with a recession is an equally likely outcome. In this case, interest
rates are pro-cyclical, with usually short-run interest rate being more markedly pro-cyclical
than long-term rates.

16. But other policy rules would imply different behaviour. For instance, if the target is mainly
inflation, during a stagflation period (a depressed GDP with high inflation) the interest rates
may be particularly high, thus a counter-cyclical pattern would emerge.

A modern economy is intrinsically linked to interest rates, thus their importance on the financial
markets. Interest rates affect consumer spending. The higher the rate, the higher their loans will cost
them, and the less they will be able to buy on credit

Why interest rates are SO important

People have asked me why interest rates matter. A modern economy is intrinsically linked to interest
rates, thus their importance on the financial markets. Interest rates affect consumer spending. The
higher the rate, the higher their loans will cost them, and the less they will be able to buy on credit.
This is how it affects inflation, If consumer spending goes down, there will be less demand for
products and services, thus prices won't rise as rapidly. Interest rates are used by central banks as a
means to control inflation.

It also affects the housing market since it will cause people who have purchased properties on too
highly leveraged loans to be unable to pay as interest rates rise. Thus they will look to selling their
properties. This will cause more property supply on the market, and lower the property prices. This
in turn will lead to others to want to cash out on their property investments which they have hoped
to hold short- term and bought on interest-only loans. If this happens too quickly, it could cause a
steep decline of the housing market.

Since most people's wealth are tied to their properties, it will decrease people's net worth.
For an economy like the US which has a large trade deficit, higher interest rates will cause more
foreign appetite for US government bonds and fixed deposits, thus resulting in capital inflows. This of
course has a negative effect in the long-term as it will push the US dollar up, and widens the trade
deficit further by making exports more expensive.

An entire library could be written on this topic. I'll save it for another time.
In a nutshell, if rate hikes continue, the economy will suffer, and may even trigger recession if
consumer spending dips too much. Interest rates will affect ALL financial markets, including but not
limited to, stocks, bonds, futures, forex, options etc.

20- Monetary Policy. Suppose real interest rate is constant and expected inflation rises. What will
happen to the current level of prices in the economy if the Central Bank does not alter its supply of
money? A rise in expected inflation will lead to higher prices today. A rise in expected inflation makes
holding money less attractive, and hence economic agents switch away from money to other assets.
A rise in expected inflation raises nominal interest rates and leads to higher current prices and lower
real money balances. That is, real balances, which have to fall, do so via a rise in prices.